Pearls and Irritations

The Covid crisis is also producing winners and institutional bond investors are winning big. Quantitative easing added to conventional monetary policy is just what they want. And so is forward guidance.

Forward guidance now de rigueur in central banking

The saying “beggars can’t be choosers” may well also apply to borrowers; particularly borrowers who are deficit countries dependent on the international capital markets.

To keep these capital markets onside, the major Western central banks have adopted a policy to keep lenders well informed of their future plans. It is called “forward guidance”, and such guidance is now standard practice in conventional monetary policy. Not surprisingly, bond traders love it.

Forward guidance is relatively new. For example in 2013, the ECB (European Central Bank) explained its recent decision to incorporate forward guidance into its monetary policy framework by providing this definition: “Forward guidance can be described as explicit statements by a central bank about the likely path of future policy rates.”

In 2018, this central bank added: “Forward guidance has become a valuable and effective policy instrument in central banking over recent years. There is by now compelling international evidence confirming that forward guidance has been successful in boosting growth and inflation outcomes by steering future interest rate expectations while central banks have been constrained in their policy space.”

Forward guidance involves the central bank providing signals to the market of its thinking on various parts of monetary policy such as the direction of rates, time frames for moves, and the extent of moves. The greater the detail, the more the capital markets are happy and unlikely to react negatively. The textbooks say that such guidance adds to market stability by avoiding surprises to investors. These investors then have more confidence in the market and are more likely to provide the funds that borrowers need.

The RBA shares this view. It has provided plenty of forward guidance in the lead-up to this current crisis.

For example, on 3 Sep 2019, AFR’s John Kehoe wrote: “It is clear from recent remarks by governor Philip Lowe and deputy Guy Debelle the RBA would contemplate QE if other central banks aggressively cut rates towards zero and the local economy faced a sharp downturn from the US-China trade war.”

Kehoe added: “‘Globally, if all central banks go to zero, then we’d have to consider that as well,” Lowe recently said. ‘We are prepared to do unconventional things if the circumstances warranted it’.”

Such statements would have been unthinkable not too long ago when central bankers kept a stoic silence so as not to tip off market players to their advantage. The report also showed just how much the RBA has reversed its thinking. Just a year before, it was refusing to even contemplate the possibility of unconventional policy, also known as quantitative easing (QE) or money printing.

On 13 Sep 2019, Kehoe wrote in “RBA reveals contingency plans”: “Meanwhile, Lowe has already engaged in a gentle form of ‘forward guidance’, which involves central bankers explaining rates will remain very low for some time or until certain conditions are met. It pushes down bond yields in financial markets by influencing expectations of future interest rates. Lowe recently pledged an ‘extended period’ of low rates, which seems to have contributed to bond yields and the Australian dollar weakening.”

On 26 Nov 2019, governor Lowe made a landmark speech, which Newscorp’s Terry McCrann lauded as “the most important speech of his time so far as governor”.

The speech noted that the world’s major central banks’ purchase of government bonds (QE) had reached nearly 30% of their GDP, from about 5% just before the GFC.

Lowe said: “A primary motivation of forward guidance is to reinforce the central bank’s commitment to low interest rates. A related motivation is to provide greater clarity about the central bank’s reaction function and strategy in unusual times. The experience has mainly been positive, with the guidance helping to reduce uncertainty.”

Crucially for bond investors, he provided a road map of future government actions. He said if the RBA were to undertake a programme of QE, it would purchase government bonds, and it would do so in the secondary market, not buy directly from governments. But the RBA would not purchase corporate bonds. Bond traders and investors, of course, are in the secondary market.

“Our current thinking is that QE becomes an option to be considered at a cash rate of 0.25 per cent, but not before that,” he said.

Bloomberg reported that government bonds rallied in anticipation even hours before the speech and gained further after.

Well-timed speech

Interestingly, his speech was well-timed because the following month, in late December, China revealed its Covid-19 problem. China critics have said that the country was tardy in providing information and that the outbreak actually happened in November or before.

Traders quickly did their arithmetic following the speech. According to an AFR report on Dec 7, “NAB’s economics team has used the RBA’s model of the Australian macro economy to make educated guesses. They find that you need to boost GDP growth by 2.8 percentage points to get the jobless rate down from 5.3 per cent currently to 4 per cent. Evidence from overseas markets implies you have to buy government bonds worth 1 per cent of GDP to lift growth by 0.2 per cent. This means the RBA will have to purchase bonds worth about 14 per cent of GDP, or roughly $266 billion, to meet its objectives. That represents almost one-third of the stock of government bonds on issue.” Such a volume of purchases would of course be pure gold for traders.

But by early 2020, the word going around was that in implementing QE, the RBA would be targeting not GDP growth or unemployment, but bringing down the borrowing cost for government to near zero.

As the virus pandemic developed rapidly, the financial system was also plunging into panic. On 16 March, Bloomberg reported that central banks were taking emergency measures to stabilise the system; that “markets were in meltdown last week on investor fears of the mounting economic toll from the coronavirus outbreak and increasingly stringent measures taken by governments to stem the outbreak.”

The same day, the Guardian online reported that “The RBA is trying to un-stick a market gummed up by coronavirus fear – but there’s only so much it can do. Since Friday, the Reserve Bank of Australia has thrown almost $15bn into credit markets in a bid to get them moving again.”

Three days later, on March 19, the RBA, in an out-of-cycle move, lowered the cash rate to 0.25%. It said it would start QE the following day. It would buy government bonds, both Commonwealth and state, but not corporates. It would buy a range of maturities with the aim to bring 3-year Commonwealth bond yields down to 0.25%. It would keep this target, and the cash rate at 0.25% until full employment and the inflation target of 2-3% was achieved.

Profit for bond investors

It’s been said that falling interest rates lift all asset classes, and this is true because near-zero cash rates make it too painful to remain uninvested. Some wiseacres call it TINA – there is no alternative. But no class is lifted more than government bonds, which is as safe as one can get to cash without actually holding cash.

Corporate stocks have to worry about multiple factors like consumer sentiment and competitive pressures. So too property, which is relatively illiquid and future supply vs. demand can be a worry. Collectables have to contend with auction market sentiment. But G7 government bonds are a pure interest-rate play. The wholesale market is liquid; there is never a lack of participants. All that players need is an idea of where central bank interest rates are heading; hence they love forward guidance.

As an indication of how much bond traders have profited, look at some prices of bond tenders on the AOFM (Australian Office of Financial Management) site. AOFM of course is in charge of Commonwealth bond tenders.

Take the Commonwealth bond maturing 21-Apr-2024. On 15 May 2019, it was trading with a yield of 1.3077%. By 4 Nov 2019, its price had climbed and yield was down to 0.8575%; on 11 Dec, 0.7525%.

And the 21-Apr-2023 bonds, which approximates the 3-year bonds which the RBA is targeting to achieve around 0.25% yield. On 1 Apr 2019, it had been trading at 1.4091% yield. By 8 Apr 2020, its yield was down to 0.2587%.

These movements represent giant gains for those institutions, the gains happening across the board for all maturities and bond types. Just before the April rescue package, Commonwealth bonds on issue totalled about $580 billion, state governments $280 billion, and non-governments $600 billion, according to RBA data. AOFM data showed foreigners owned about 58% of Commonwealth securities.

Usefulness of QE

Knowing the RBA’s target yield, when that yield is reached, traders would want to sell at least part of their holdings and lock in some gains. That target has been reached for the time being. The problem for them is that everyone will also be wanting to sell, and few if any wanting to buy.

That’s when the RBA’s QE buying programme becomes useful. The buying started on 20 March 2020. In the three weeks to 10 April (Good Friday), it bought about $37.4 billion of Commonwealth and state bonds, according to the RBA. In the same time, the AOFM sold only about $6.6 billion Commonwealth bonds, which indicates some traders took the opportunity to unload their holdings to the RBA and take a profit.

For those who may want to get in on the bond market, it’s not so easy. Minimum bids at AOFM tenders are $5 million and only approved institutions are permitted. Similarly, only approved institutions may participate in the secondary market and in RBA bond buying. While it is true that some Commonwealth bonds are listed on the ASX, volume is very low.

John Tan was a deputy editor in the Straits Times newspaper in Singapore. He has been foreign editor and business editor.

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