How Aussie QE will work

Today I write that it is amusing how we have shifted from nobody believing our early May forecast that Aussie quantitative easing (QE) was coming, to it suddenly becoming the consensus view as the Reserve Bank of Australia grapples with an effective lower bound on its target cash rate. In fact, there are interest rate strategists who think that government bond yields are already pricing in the likelihood of Aussie QE. Many of the folks who were dismissive of our May call are now expressing strong opinions on precisely what form the RBA’s QE will and will not take. Most of this analysis is misguided and overlooks several complications. I also highlight a serious technical error in the latest RBA research paper on QE. To read the full column, click here or AFR subs can click here. Excerpt only:

So why is the current QE thinking so muddle-headed? First, buying government bonds is unlikely to do much good in Australia. The RBA’s former deputy governor, Stephen Grenville, explained why during the week, although he overlooked the alternative solutions. Because most Australian private debt is floating-rate, as opposed to fixed-rate, it prices off the short-term cash rate plus a credit spread, or risk premium, rather than long-term government bond yields. As a consequence, all Australian banks hedge their wholesale funding back to a spread above the cash rate or a proxy therein, such as the bank bill swap rate, which itself embeds a bank credit risk premium.

This means that the RBA buying long-term government bonds is not going to do much to influence domestic rates. It might put downward pressure on the Aussie dollar, which will be stimulatory. But even this outcome is uncertain because the exchange rate is determined by global forces over which the RBA has limited control. Indeed, restricting Aussie QE to government bonds exposes the RBA to non-trivial reputational risk if it is perceived to fail.

Another concern with buying government bonds is that doing so could further reduce bank profitability in a climate where they already face a multiplicity of return on equity headwinds. APRA and the RBA require banks to hold up to one-third of all government bonds as part of their emergency liquidity books. If the RBA crushes the interest rates on these assets, it will crimp bank profits and reduce the probability that they improve product rates.

The one area where QE is likely to have a profound impact on savings and borrowing rates is if it compresses the risk premium above the cash rate that banks fund themselves at. As I have explained before, credit spreads on the banks’ senior bonds are some 8 to 10 times wider than they were in 2007 and elevated by global standards, even though risk-weighted leverage has halved. It is well known that Aussie banks have to pay materially more to raise money in global markets than similarly rated peers. Our internal analysis shows that this is driven by the skinny pool of capital domestic super funds make available for investments in local fixed income given their huge equity biases (the latter is an artefact of super funds being judged based on their raw, not risk-adjusted, returns, which motivates them to chase the riskiest possible equity, not debt, investments).

The good news is that there are many ways the RBA can crush this intermediated cost of capital while also ensuring banks pass on the savings to customers...