A Controversial Call & What It Means for the Australian Investor

This week we make a perhaps controversial call that goes against the grain of what every leading economist, including the RBA governor, has consistently said. That is, the cash rate will go to 0% before the end of the calendar year (which I previously alluded to in my article last week, though I did say 0.1%) and negative in the first half of next year assuming the current economic trajectory holds. How is this going to affect us in Australia? Bear with us, we’ll get there.

Author: Sid Ruttala

Going back to the GFC, the RBA had a lot more breathing space in terms of monetary stimulus, including a reduction in the cash rate to 3%. This is something that seems immensely high now but it was in fact a reduction of more than 400bps from the September of 2008 to September 2009 (i.e. 7% down to 3%). What has been evident ever since is a reluctance and, in my view, a total inability to normalise policy. Conventional wisdom suggests that this is due to a lack of inflation and economic uncertainty, but I would suggest that the more important driver is the stability of the financial system (think banks and housing), excessive debt and an unwillingness to let asset prices take their due course, that is to say an aversion to correction. 

Before I elaborate further though, for those of you unaware of how the cash rate actually works in practice, a brief detour to Economics 101 can be found in the box below. 

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To The Present

Now that I have briefly summed up how the theory works (or tried to), let's get back to the present. I will begin with a couple of simple questions, what happens when the velocity of credit and transactions in the real economy is such that the demand for ES doesn’t go up naturally because credit growth is stagnant? What happens when the financial system or lenders become reluctant to lend despite the opportunity cost of holding ES funds?

The neo-classical nonsense that we’ve all been programmed to believe would suggest that this should not happen since all economic actors are definitely 110% rational (the notion that humans will always act rationally is beyond farcical). Similarly, in an efficient market, buying short-dated securities by a central bank (be they 90-day bills or anything else) should result in the differential across same duration asset classes of similar risk ratings being whittled away. But what happens if it doesn’t? This played out just last year in the September 2019 repo market panic where rates shot up to 10% despite a Fed Funds rate of 1.5% - 1.75%,  this subsequently required the injection of tens of billions of dollars into the overnight market. Commentators aplenty have suggested that this is due to Basel requirements and post-GFC regulatory innovations that force financial institutions to have capital adequacy requirements that are more stringent than would otherwise be the case. But it points to a more fundamental problem, markets simply  aren’t efficient because, despite the economic textbooks, institutions (including financial) and markets in general are made up of people. This is the reason why banks in Europe and Japan don’t pass on negative interest rates to their customers (imagine the marketing). 
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So, if traditional monetary policy isn’t doing the trick, where to next?

The Cash Rate

​“The cash rate is the interest rate on unsecured overnight loans between banks.”

- Reserve Bank of Australia

This is the reason why it is also known as the interbank rate. Given the duration of these loans, the interest rate associated should move in tandem with other instruments, such as short-duration deposits and 90-day bills, given that they are effectively substitutes. Think of it this way, two or three houses that sit next to each other on the same street generally move proportionally in the same direction.
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If there are discrepancies between the price and yield of these substitutes, the mechanisms of the market will typically arbitrage it away in an “efficiently” functioning system. Where this does not happen, as in the repo fiasco of September 2019, it requires the lender of last resort, the Federal Reserve in that case, to step in (but more on that later). For now, the point is that the cash rate is effectively the yield on interbank loans and should only be slightly lower than shorter duration assets. 

Turning our attention to the banks and how changes to the cash rate are usually passed on, banks need to lend to and from each other in the overnight cash market. These funds are then settled in the Exchange Settlement (ES) funds market, for which they hold deposits with the RBA. Thus the cash rate in this instance is the rate of return that banks get for holding these deposits (though ES deposits are theoretically supposed to yield 0.25% less than whatever the target cash rate might be). They hold them for both legal (capital adequacy) and economic reasons. Companies that need to pay tax remittances to the ATO through say NAB, for example, would require NAB to settle the payment via ES balances. In a similar manner, if us mere mortals wished to transfer between ourselves (between our respective bank accounts), those two banking institutions would again be required to settle those transactions through ES balances. Thus banks are always required to have positive ES balances, in the absence of which they would have to borrow on the interbank market or directly from the RBA (which they can do at 0.25% above whatever the cash rate is).

The above mechanism is necessarily pro-cyclical. This is due to the fact that as the level of economic activity rises, the demand for ES funds rises with it and vice versa (i.e. transfers or transactions increase as economic activity increases). This puts a natural upward pressure on the cash rate if the economy is doing well. The central bank, if it wished to maintain the target cash rate, would have to step in via open market transactions through the buying of securities (which can theoretically be any securities but typically short-duration assets, such as treasuries). These transactions would typically be done through the use of repurchase agreements, or repo, which is an agreement for the purchase and sale of securities with a simultaneous undertaking to reverse the transaction at an agreed upon price and date (typically 24-hours). So, if it wanted to lower the cash rate again, the central bank would buy securities since this would create additional supply in ES funds. Or, if it wanted to raise the cash rate further, do the opposite (i.e. sell securities). In this manner the cash rate can be used to counter economic cycles since the natural incentive when the rate of return on ES funds is lowered is to lend more and vice versa.

QE & Negative Rates: A perverse but irreversible next step

Now this is where we remember that the cash rate is a target maintained via open market transactions through the buying up of securities. Typically shorter duration to give liquidity into the financial system. 

QE is no different except for the fact that it goes up the duration/risk curve. This effectively creates a scenario of increased liquidity as you keep trying to ensure credit growth through to the real economy (credit is the growth in debt, by the way, and not overall debt in itself). This was the reason the RBA decided to create TFF (term-funding facilities) for small businesses during the Covid-crisis in Australia, effectively backstopping and guaranteeing a lower cost of capital for ADI’s (Authorised Deposit-Taking Institutions). It is why the Australian Office of Financial Management (AOFM) effectively guaranteed loans to SME’s. It is why the RBA decided to purchase Australian Government issued treasuries directly on market.

As more liquidity comes into the system via ES funds (due to on market purchase) there is also downward pressure on the cash rate even if the official target hasn’t changed (demand-supply).

If this increase in liquidity still doesn’t work then the next logical step is one of two alternatives (or both). 

The first is yield curve control, or the buying up of securities further up the yield curve and bonds, and on it goes, with the intention of building ES funds. Globally, we have seen this in the expansion of the Fed’s balance sheet to $7tn USD and, despite it arguably being illegal (in the absence of an act of Congress),their buying up of corporate debt. In Japan, this has included putting equities risk on the balance sheet of the Bank of Japan (the central bank buying shares what a novel idea).

Has it worked? It is hard to definitively say unless we can show ‘what if” scenarios, which would undoubtedly be open for debate anyway. Unfortunately (or fortunately?) for us investors, what has been evident is that this whole scenario has seen the excess liquidity not driven into the real economy (why CPI has arguably been dead since the GFC despite the availability of so called ‘cheap money’) but through asset price inflation. That is, the reduction in the supply of supposedly ‘risk-free’ assets and the opportunity cost of short-duration leads to allocations higher up the risk curve. Money has been devalued, just not necessarily against what we like to measure it (CPI). The markets might be irrational in the short-run but never over the long-run. To reduce the word count and to avoid any more headaches amongst the readership, I won’t go into the lunacy of using CPI (created for a post-WWII industrial world) 75 years on.
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The other alternative is to go in the European direction (the Japanese chose to do both), toward negative interest rates. Remember that markets work not just based on nominal cost but also opportunity cost which can not only come from interest rate differentials but also inflation. Negative interest rates are a way of saying, in the absence of inflation (and if we can't get it), just do what it (inflation) effectively does by eating away purchasing power and thus get the velocity of transactions on track. The efficacy of such a strategy is still contested and this author does not wish to get into that particular debate (that might get political rather quickly despite monetary policy supposedly not being so.

What has already been indicated closer home? 

​What has already happened is the buying up of newly issued Australian treasuries, ending up on the balance sheet of the RBA. Despite Lowe ruling it out as a credible alternative in the initial stages of the crisis, the RBA intervened directly to keep the effective yield on Australian government debt as close to the cash rate as possible or within a band around it. More recently, Assistant Governor Kent has indicated that the RBA might move further out in the yield curve to supplement the existing three-year yield target. This is something that we see as required given the amount of government issuance likely to take place in the coming years. 

As a matter of fact, the current cash rate is already trading at 0.14% (due to the amount of open market transactions that are already being undertaken). As such, I wish to make the call that I’m even more bearish on the downside to 0% by year-end. 

A normative thesis around potential negative (Cash Rate)? 

The negative rate call is a controversial one but in my view it is a necessity if one were to navigate a way out of the current situation. What has been missing since the GFC was an inertia on the part of governments to do the heavy lifting. While we had expansionary monetary policy, fiscal policy was going in the opposite direction  due to political inertia in most cases. 

Even at the best of times monetary policy is a blunt instrument. Think about how the ES and open market transactions work, they are naturally adept at raising the interest rate and behaving countercyclically on the upside, thus effective in counteracting inflation. Monetary is not created for the purpose of creating economic policy or stimulating growth (they simply don’t have the toolbox nor the aptitude for it). Though the RBA has lofty aspirations across both (not to mention inflation, employment and currency stability). Unless you want technocrats taking the lead on industrial relations, you will be trying to fit a square peg into a round hole. 

Now that fiscal policy has joined the fray, negative interest rates can effectively keep the cost of serviceability on newly issued debt down to a level that won’t put excessive burden on the taxpayer in the short-run (and thus be contractionary). Again, for the economists amongst you, I refuse to accept the nonsensical ramblings of the RBC (Real Business Cycle) prophets or the far-fetched notions of Ricardian Equivalence that have guided our policy making for the past three decades, including the ever so famous Reaganomics. 

There will be pain, especially for lenders, but the piper has to be paid. The QE policies and general monetary policies created a 30-year bull run in bond markets. Negative might see them have a final hurrah up but reversion to the mean has always been the principle upon which the capitalist market has relied. Especially so should inflation come back into the equation in this scenario. The hint is in the name, correction.

Another controversial call, but the disclaimer by most central bankers around the world is that they will let inflation shoot above target at least for a short period of time, should tell us how they feel about the unravelling of the gigantic balance sheets any time soon or raising rates. 

For us at TAMIM and me personally, equities and steady (or as steady) as she goes. At the very least, we know that central bankers are also human and typically in a demographic that ensures at least a modicum of collective guilt about pushing the pension system into risk assets. The only way out is to de-risk those assets as much as possible and allow the music to continue playing for as long as possible.