Melbourne Cup Day 2020 will be memorable for a few significant reasons:
- First, because of COVID restrictions there will be virtually no one at Flemington racecourse to witness the race or welcome the victor back to the winner’s circle;
- Second, the RBA will meet and will likely announce a further cut in cash rates (from 0.25% to 0.10%) and declare that its Quantitative Easing (QE) program will be expanded with no termination date; and
- Third, whilst Australia recovers from partying and sleeps on Melbourne Cup night, the US will conduct its Presidential election.
The hints as to what the RBA is likely to do have been well and truly signalled in recent speeches. The RBA now seems committed to fully informing the market of its thinking. Thus, as interest rates fall towards zero and QE is rolled out with tens of billions of dollars printed, the market will be unperturbed. The markets will be more surprised if these policies do not happen. That is the perverse market environment that we have entered.
Last week’s speech by RBA Governor Phil Lowe included three important points and so we have published it below with our thoughts on the consequences for investors – particularly for self-directed retirees in pension mode.
RBA Governor Philip Lowe in deep contemplation
In summary, the Governor signalled a further policy easing in early November. The speech has created market expectations that both the cash rate and the 3-year bond yield target would be cut from 0.25% to 0.1%. Further, the market now has no doubt that the RBA is likely to start buying up both 3-year and longer term government bonds as part of a large QE program.
Governor Lowe positioned his commentary inside a policy target for employment conditions that will need to become sufficient for wages growth that in turn leads to “cost push” inflation. He stated:
“We want to see a return to labour market conditions that are consistent with inflation being sustainably within the 2 to 3 per cent target range.”
Further, he made it clear that low interest rates will be a feature of the economic (and thus investment) environment for many years to come.
“The Board will not be increasing the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range. While inflation can move up and down for a range of temporary reasons, achieving inflation consistent with the target is likely to require a return to a tight labour market. On our current outlook for the economy – which we will update in early November – this is still some years away. So we do not expect to be increasing the cash rate for at least three years.”
There you have it, the RBA is telling markets (and you) that it will target interest and cash rate settings that will be substantially below inflation. Further, if inflation does reach the target range (sustainably between 2% and 3%) then it will consider tightening (raising rates) but only when the labour market tightens.
Re supporting economic recovery, the Governor offered 3 remarks that are well worth reviewing. However, as we do review them we do so with a touch of scepticism, for we note that the RBA had for years debunked QE and low or negative interest rate policies.
“Turning to the broader policy question, we have been considering what more we can do to support jobs, incomes and businesses in Australia to help build that important road to the recovery…
The first is how much traction any further monetary easing might get in terms of better economic outcomes. When the pandemic was at its worst and there were severe restrictions on activity we judged that there was little to be gained from further monetary easing. The solutions to the problems the country faced lay elsewhere. As the economy opens up, though, it is reasonable to expect that further monetary easing would get more traction than was the case earlier.”
The RBA pushed the Government and Treasury to be aggressive with fiscal policy as the primary support mechanism for the economy in “free fall” as the virus restrictions took hold. The RBA view was that cash handouts were the quickest way to sustain the economy at a level higher than depression. Since no one would borrow (other than Government/s) cutting interest rates was of limited use. However, that comment seems to forget that cash rates were cut to 0.25% in March – a historic low for Australia.
Official cash rates in Australia over last 20 years
“A second issue is the possible effect of further monetary easing on financial stability and longer-term macroeconomic stability. This is an issue that we have paid close attention to in the past when we were considering reducing interest rates in a relatively robust economic environment. It remains an important issue today, but the considerations have changed somewhat. To the extent that an easing of monetary policy helps people get jobs it will help private sector balance sheets and lessen the number of problem loans. In so doing, it can reduce financial stability risks. This benefit needs to be weighed against any additional risks as people take more investment risk in the search for yield. We also need to take into account the effect of low interest rates on people who rely on interest income.”
This second point outlines the pros and cons for cutting interest rates towards zero. However, it fails to declare the obvious: that the RBA has decided to sacrifice savers (and particularly those needing low risk income) for those that can borrow at low rates or those in financial distress who cannot service their debts.
We agree that financial stability is a crucial issue for the economic recovery but there is recent history in the US as to what an appropriate response should be. In October 2008, when Lehman Brothers collapsed, the Federal Reserve injected US$120 billion of preference capital into the nine most significant US financial institutions. The aim was clear – to make the banking system of the US undeniably strong, and it worked.
The Troubled Assets Relief Program (TARP) combined the purchasing of troubled loans (by the US Treasury) from the banks with the issuance of non-voting (preference) equity by the banks to Treasury.
As noted in the chart below, the effect was not immediate, but it ensured that recovery, when it came, would be supported by well-capitalised banks. Eventually the Treasury capital was redeemed by the banks as economic recovery flowed from 2010 to 2014.
Source: Federal Reserve of St Louis
Our view is that the RBA and Treasury should consider a TARP strategy to ensure that Australia’s banks are very well capitalised and able to let credit flow, even if they are supporting a troubled loan book. Given the resurgence of COVID across Europe and the US, it is likely that Australia’s borders will not reopen until 2022 and so we cannot wait to be aggressively pro-active with policy settings.
“A third issue is what is happening internationally with monetary policy. Australia is a mid-sized open economy in an interconnected world, so what happens abroad has an impact here on both our exchange rate and our yield curve. In the past, the interest differentials provided a reasonable gauge to the relative stance of monetary policy across countries. Today, things are not so straightforward, with monetary policy also working through balance sheet expansion. As I noted earlier, our balance sheet has increased considerably since March, but larger increases have occurred in other countries. We are considering the implications of this as we work through our own options.”
This final statement confirms what we have been saying in The View for years. The RBA was wrong to not have a QE policy developed before the COVID crisis. To watch Japan, the US and Europe access endless QE after the GFC with no Australian policy response showed poor judgement.
Indeed, in a world that broke down trade barriers and reduced restrictions that had inhibited international capital flows, the ability to understand the repercussions for Australia’s exchange rate and the relative cost of borrowing was seemingly not apparent to the RBA – at least in their public statements.
Melbourne Cup Day 2020 will be a momentous day for Australia, with confirmation that we are well entrenched in a sustained period of hideously low interest rates.
Underlying that forecast are the following two observations:
First, no one should believe that the RBA is confident that its policy response will work. Indeed, they have stated, and it is obvious across the world, that zero or negative real and actual interest rates do not stimulate private investment. They make it cheap for both government investment and surging cash handouts that eventually create mountains of debt.
Second, it is absolutely time for income investors to review the yield and the quality of their investment portfolios. The RBA is clearly not concerned with your pain and actually expects that you will be forced to draw down capital to support your cash income needs. Your immediate need is to examine your portfolio, and perhaps to delay the need to draw down capital for as long as possible.
Now is an opportune time to discuss your asset allocation and portfolio structure with your financial advisor. Let us help you consider all the options available to you … it has seldom been more important.