QE likely to pack a punch with bonds in short supply

A bond buying program by the Reserve Bank in 2020 would pack some punch, and is likely to be much smaller than expected.

Philip Lowe, governor of the Reserve Bank. Picture: Bloomberg

A bond buying program by the Reserve Bank in 2020 would pack some punch, and is likely to be much smaller in scale than some have estimated.

With the RBA’s official cash rate cut to a record low of 0.75 per cent at the start of this month, and with a further cut in coming months seemingly locked in, quantitative easing is considered a strong possibility.

So, figuring out how QE might play out in a small, open economy like Australia’s, and with a limited government bond market to play with, has become critical for markets and policymakers alike.

The mathematics runs a bit like this: there’s about $600bn ($US409bn) of government bonds on issue. Around two-thirds of them are tightly held by foreign central banks and foreign pension funds. Australia’s retail banks also hold a significant portion to meet tightening capital adequacy requirements.

That leaves what some are calling the “float”, or the liquid pool of government bonds at around $150bn.

Some economists are worried that if the RBA has only a tiny pool of bonds that it can hope to buy, the impact of a QE program might be limited.

But think again. In fact, turn that on its head.

Limited bond market liquidity means the presence of the RBA standing in the market as a buyer would give it heightened leverage. Tight supply implies the RBA may only need to wade a little into the shallows in order to create some big waves.

The government yield curve is already flat and yields are at record lows, reflecting anticipation in the market that the RBA will invoke QE next year.

There’s no shortage of market commentators factoring QE into their forecasts. Just the threat of QE is already having an impact, reducing the size of the stick the RBA will need to wield next year.

RBA deputy governor Guy Debelle touched on this issue in a speech last year, saying that a small bond market would add to the effectiveness of a QE program in Australia.

“QE is a policy option in Australia, should it be required. There are less government bonds here, which may make QE more effective,” he said in a speech on the lessons of the global financial crisis.

So, the RBA is probably quietly confident that if it needs to wheel out the weapon, its QE gun would pack some punch.

It’s worth asking what the intentions of the RBA’s QE program would be. It’s more than likely that if bond buying is announced, it will be in the absence of dysfunction in funding markets. There’s no Lehman-style crisis (only visible through hindsight) in the offing.

So Australia’s QE program will simply seek to win ground across the yield curve, mostly amid shorter-dated securities, keeping the transmission mechanism of monetary policy well-oiled.

Critically, the other function of QE will be to ensure maximum downward pressure on the Australian dollar.

RBA governor Philip Lowe said in Washington last week that a lower Aussie dollar was nearly always the more potent weapon of monetary policy. That’s even more so when official interest rates are at record lows and local banks resist passing on all of the official rate cuts. Lowe described these channels as “muted.” That’s an understatement.

QE will be needed next year so that the RBA can continue to sell a message that it has the firepower to keep the Aussie dollar low. If it loses that, it would result in a disastrous rise in the currency.

The Aussie dollar fell by 40 per cent as the GFC washed into banking systems worldwide in 2008, keeping the economy afloat in some truly dark times.

So expect the RBA to quickly begin a more forthright discussion around QE if it cuts interest rates again. February looks likely, but a case could be built for November or December. The RBA board does not meet in January.

Governor Lowe has already done the smart thing and announced a form of explicit forward guidance.

His mantra of recent months that interest rates will remain low for as far as the eye can see is more than just a means of lifting the spirits of those with debt — it’s a message to currency markets that interest rates will stay low or continue to fall, so don’t buy the Aussie dollar.

Dow Jones