Bond yields soar as RBA stays out of interest rate battle

A sustained rise in bond yields could put upward pressure on fixed-rate mortgages, potentially cooling the housing market and slowing consumer discretionary spending.

Economists are now expecting an early end to yield curve targeting and a quicker rise in interest rates. Picture: AAP

The battle over interest rate expectations was won by the bond market.

Rather than defend its target of 10 basis points for the April 2024 bond – which had served to reinforce its “forward guidance” that its cash rate target won’t rise from 10 basis points before 2024 – the Reserve Bank stayed out of the market despite a massive overshoot of its target, sparking an even bigger move up in yields, which pushed the sharemarket down to a two-week low.

Economists said the market was being unrealistic about the pace and timing of interest rate hikes, but a sustained rise in bond yields would put upward pressure on fixed-rate mortgages, potentially acting to cool the housing market and slow consumer discretionary spending.

With the RBA remaining silent at its 11:15am announcement window, the April 2024 bond yield soared from 41 basis points to 81 basis points, adding a massive 24 points for the day and 70 basis points for the week, as it was pre-priced toward where it would be if the target were dropped.

The 3-year bond yield rose 10 points to 1.225 per cent, up 49 points for the week, while the important 10-year bond yield rose 24 points to 2.09 per cent, hitting a post-Covid high of 2.12 per cent.

The ASX 200 share index fell 1.4 per cent to 7323.7 points, with the real estate, financials and consumer discretionary sectors underperforming the index and banks under pressure, albeit mainly because investors were raising funds to participate in a $1.5bn capital raising by Macquarie Group.

The capitulation of the RBA, after inflation data for the September quarter showed the underlying “trimmed mean” CPI regained the low end of the RBA’s 2-3 per cent target band for the first time since late 2015, led economists to predict earlier end dates for the RBA’s “unconventional” policy tools – including yield curve targeting and bond buying – and earlier and faster rate hikes.

CBA’s head of fixed income and currency strategy, Martin Whetton, said a “lack of communication” from the RBA this week “while perplexing and frustrating” was leading the market to conclude the target will be dropped as soon as Tuesday’s RBA board meeting.

“While dropping the yield curve target was not mentioned in the most recent RBA communications, it seems the most logical forward course from here,” he said.

Investors were “unlikely to be dissuaded from believing that a rate move is coming before 2024 regardless of what the RBA says or does from here”.

Defending the target probably would not have stopped the move higher in yields and ran the risk of the RBA buying bonds at “much lower yields than are realistic into the time of its maturity”.

But in his view, dropping the yield target would be “equivalent to removing the forward guidance”.

“This presumably means the RBA being more open to countenancing a move before 2024,” he said.

A rate hike before that year had been priced into the market when RBA governor Philip Lowe recently gave a speech highlighting that he disagreed with market pricing.

But both the market pricing and the data, particularly the CPI, had “shifted since materially” since that speech, so a very different tone may be struck by Lowe when he next speaks publicly.

“However, while he may well countenance a rate hike in 2023, we expect the RBA will consider current market pricing too aggressive,” said Mr Whetton.

“The RBA has set out to push inflation back materially and sustainably into the band, ‘not just to 2.1 per cent’.”

NAB economists shifted their view to predict the first RBA rate rise in mid-2023 and a “relatively aggressive series of hikes” to a 1.75-2 per cent cash rate by the end of 2024 from 0.1 per cent now.

Ahead of next Tuesday‘s board meeting, they forecast the central bank would end its yield curve targeting, and “pivot fully to outcomes-based forward guidance.”

Yield curve targeting is set to end because the RBA showed “little commitment“ to the 0.1 per cent April 2024 target after a massive overshoot on higher than expected inflation data.

Quantitative easing (RBA bond buying) was predicted to end by February 2022, with NAB seeing “little use for the policy with most other central banks ending or tapering their QE programs”.

But while outlining why they now expect unconventional policy to end, they argued that market pricing of four rate rises in 2022 was still unrealistic.

Core inflation was likely to remain around 2.3 per cent for some time before supply constraints eased but wages growth above 3 per cent was a “key requirement to sustain inflation in mid target”.

JP Morgan Australia chief economist Ben Jarman said the RBA’s absence on the April ’24 bond was a “very significant surprise” since it bought $1bn of the bond a week earlier after a smaller move.

“The only conclusion we can draw is that the yield curve control regime is about to be formally dumped at next week’s meeting,” he said.

This would be a “startling about-face” by the RBA as it would mean its official guidance about the conditions required to hike rates “appears no longer binding”.

Only one stronger core inflation result has been registered, and wage growth is a long way from rising “materially”, a near-necessary condition for sustainable achievement of the inflation target.

RBC rates strategist Simon Deeley said a shift in communication from the RBA consistent with a faster exit from QE and early start to rate hikes may come via a shift to a shorter dated bond target, a change to the target level or “abandonment”, which was his expectation.

Upward revisions to core inflation forecasts to above 2 per cent through the forecast period, and a shift in language to note “uncertainty” over the potential persistence of higher inflation and a focus on whether “hot spots” of wages growth become widespread, and noting the strengthening recovery post-lockdown was also on the cards, he said.

“We expect a change to the RBA’s forward guidance of 2024 through either yield curve control changes or old-fashioned jawboning hinting at an earlier rate hike lift-off in 2023.”