Central banks’ credibility is eroding

If inside-the-beltway experts are to be believed, Treasurer Jim Chalmers will announce in July a new female Reserve Bank of Australia governor, likely insider Michelle Bullock, to succeed incumbent Phil Lowe.

Precisely when Lowe goes, nobody knows. There is a school of thought that he should be left to complete this cycle. Either way, time is not Lowe’s friend with core inflation running about double the mid-point of the RBA’s 2 per cent to 3 per cent target band and its own research suggesting it will not return fully to target until 2026.

Pressure on the RBA to catch up to global peers intensified overnight with the Bank of England shocking economists with a half-percentage-point increase in its policy rate. This brings the BoE’s policy rate to the 5 per cent threshold that the US Federal Reserve and the Reserve Bank of New Zealand have already passed. The Bank of Canada is not far behind at 4.75 per cent.

One interesting facet of the BoE move is that long-term interest rates declined after the surprise 50 basis point increase. This is because investors are starting to price in recessions more aggressively in response to the higher-than-anticipated jump in the short-term rates controlled by central banks. In the financial lexicon, the yield curve is inverting as the level of long-term rates falls below the central banks’ overnight policy rates.

The odd man out is, of course, Australia with its 4.1 per cent cash rate and house prices that every day storm higher after the second-largest correction in history between May 2022 and February 2023.

The RBA is undoubtedly concerned about its eroding credibility, which could in theory be deteriorating faster than global peers given its comparatively sluggish tightening cycle and the fact that Lowe himself has been lambasted harder than other central bankers because of a series of perceived mis-steps that have precipitated his early removal.

In the US, the Gallup poll shows that public confidence in the Fed had plunged to its lowest point since the survey began in 2001. The worry for the RBA will be that consumers and businesses don’t believe it has the fortitude to snuff out this inflation crisis, entrenching expectations of higher future inflation that will further amplify the nascent wage/price spiral.

NSW debt punt

Escalating interest rates are also perturbing Australia’s best treasurer, NSW’s Daniel Mookhey, who revealed during the week that the previous Perrottet government had indeed hatched an extraordinary plan to issue $25.3 billion of extra taxpayer debt purely to allow its investment arm, TCorp, to punt this money in global stock, junk bond and property markets.

The Australian Financial Review was the first to unearth the proposal back in mid-2021.

“Upon becoming treasurer, I learnt about a plan concerning the state’s Debt Retirement Fund,” Mookhey exclaimed during the week.

“I was told that the previous government intended to raise $25.3 billion of debt to deposit into the Debt Retirement Fund. That money would go towards buying foreign and domestic stocks and bonds. It would be used to invest in property, here and abroad, and it would be invested in hedge funds, high-yield funds, bank loans and other alternative assets.

“The hope was that we would gain more from owning those [risky] assets than we would have to pay for the debt needed to buy them. Simply put, NSW would play around in financial markets using its credit card.”

Mookhey highlighted that $25.3 billion is nearly enough to build the entire Sydney Metro West project. “It is enough to build three more tunnels under Sydney Harbour. That money could be used to build 300 public schools or more than 40,000 social and affordable homes.

“Yet we are raising that much debt to bankroll Australia’s biggest-ever carry trade. That plan is exceptional because NSW will have soon used borrowed money to artificially build the biggest sovereign wealth fund owned by a state government worldwide.”

There was only one vested interest that benefited from turning NSW into a huge leveraged hedge fund: the people that taxpayers were paying fees to run the money. This included TCorp and the fund managers they farm cash out to. The average total compensation per person across TCorp’s 204 staff was $283,078 last financial year. That is 81 per cent higher than the average compensation the notoriously generous RBA paid its staff over the same period.

When this newspaper first disclosed Perrottet’s plan to borrow more than $25 billion to put into a Debt Retirement Fund (DRF) that he established in 2018 to, ironically, reduce debt, the government acknowledged the scheme but denied it wanted to borrow anything like this amount. It countered borrowings would only be about $10 billion. This has proven to be false, as we had argued at the time.

After enormous pressure was brought to bear on Perrottet to use the $26 billion in the DRF, which was originally funded by the sale of NSW’s infrastructure, for its legislated purpose of alleviating NSW’s soaring debt burden, he belatedly drew down on $11 billion for debt repayments in late 2021, which was unprecedented.

Yet despite losing NSW’s AAA credit rating from Standard & Poor’s in 2020, which the DRF was expressly designed to protect, and NSW’s debt exploding from $58 billion in 2018, when Perrottet established the DRF, to more than $163 billion this year, he refused to use the remaining $15 billion in the DRF for additional debt reduction.

Of course, the interest bill on this debt was also multiplying from about 1 per cent annually on a new 10-year NSW loan in 2020 to 4.8 per cent today.

And as Mookhey has discovered, Perrottet’s government proposed to issue another $25 billion of debt to (paradoxically) put in a debt-reduction fund purely because he had been convinced by TCorp and others that gambling this borrowed money on global markets was a good trade. Heads fund managers win, tails taxpayers lose!

Mookhey explained that there was, in fact, more to this story. “It turns out that swelling the size of the DRF with debt makes the budget look healthier than it is because the budget assumes we earn a return of 7 per cent on every dollar we deposit into the fund, even when it is losing money,” he said. (It lost money last financial year.)

“If those returns are stripped out of the budget forecasts, NSW will not post a budget surplus any time soon. In fact, we will record deficits every year over the forward estimates.

“The plan to deposit $25.3 billion more into the DRF using debt will increase our gross debt levels by $27.8 billion by June 30, 2027. By June 2026 we will owe our creditors a total of $188 billion. This is the largest debt any incoming state government has inherited from its predecessors in more than three decades.

“In three years’ time, the state will be handing our lenders $7 billion in annual interest payments. This is billions more than we spend to fund the entire NSW Police Force.”

Bondholders score

The only constituency that benefits from higher interest rates is, of course, the bondholders. On Monday, Westpac issued $2.9 billion of five-year, and 10-year Tier 2 bonds that paid incredible interest rates of 6.5 per cent and 6.9 per cent annually. There was some speculation that the Future Fund might have been getting in on this action. (We bought $236 million.)

Those Westpac rates are more than you earn on the dividends on Aussie equities, even if you gross up those dividends with franking credits. Naturally, the banks do not like having to pay stonkingly, high interest rates on their bonds – but they have no choice.

The regulator prescribes very precisely how they fund themselves. Most of their money comes via bank deposits, which is the cheapest funding a bank can source. They are then required to issue a certain percentage of funding via long-term bonds to provide a minimum level of financing stability.

The regulator also insists a certain share of their funding must come from first-loss equity, followed by second-loss hybrids, and then finally higher-ranking Tier 2 bonds that sit above hybrids but below senior bonds in their capital structure priority.

For decades, borrowers made out like bandits. Today savers are in the ascendancy.

Find out more about Coolabah's new Floating-Rate High Yield Fund here. First published in the AFR here.