RBA guides to lift-off in 2023; AUD 5y5y is high outright & v. USD

The RBA lifted their growth and inflation forecasts at their November 2021 meeting, and dropped the yield target for the April 2024, but pushed back on market pricing. The text implies lift-off in 2023, and Gov Lowe said that a first hike after the maturity of the April 2024 was still plausible in the press conference — but the RBA has wisely stayed away from date-based forward guidance.

While the short end is fully priced if you trust the RBA, I’m wary. The high absolute level of long end rates suggests that this is a decent time to receive the long end. I think AUD 5y5y looks high at 2.6%, and looks very attractive at ~70bps over US 5y5y.

The decision

The RBA dropped the 10bps target for the April 2024 bond, and didn’t replace it with anything. It left the interest rate target at 10bps and the ES bid rate at 0bps; it also left the QE program unchanged at 4bn per week.

The decision to dump the yield target was couched in terms of the better economy, progress toward the inflation target, and the pointlessness of fighting the market. In the press conference, Gov Lowe emphasised the economic recovery. The policy was aimed at building a bridge, and we’ve arrived at the other side.

The decision to discontinue the yield target reflects the improvement in the economy and the earlier-than-expected progress towards the inflation target. Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished.

RBA post meeting release, 2 Nov 2021 (my emphasis)

In the post meeting statement, the RBA noted the tailwind from faster-than-expected reopening, and high vaccination rates. They upgraded 2022 GDP (+125bps to 5.5%), left the unemployment track unchanged (at 4.25% in Q2’22 and 4% in Q4’23), and boosted the core inflation path by 50bps in 2021 and 2022 (to 2.25% in Q4’21 and Q4’22), and by 25bps in 2023 (to 2.5% in Q4’23).

The pushback

The RBA characterised inflation as ‘still low’ in underlying terms. They expect the annual pace of core inflation to track around 2.25%yoy until 2023, when it rises to 2.5%yoy. A key reason that core inflation is expected to remain low is that wages growth is expected to pick up from the current 1.7%yoy only gradually, reaching 2.5% in 2022 and 3% in 2023.

In the press conference, Lowe said that he expected goods inflation to ease as services consumption and international travel returned to normal over the next few quarters.

The inflation paragraph is worth reading in full, as it really is the meat of the November statement.

Inflation has picked up, but in underlying terms is still low, at 2.1 per cent. The headline CPI inflation rate is 3 per cent and is being affected by higher petrol prices, higher prices for newly constructed homes and the disruptions in global supply chains. A further, but only gradual, pick-up in underlying inflation is expected. The central forecast is for underlying inflation of around 2¼ per cent over 2021 and 2022 and 2½ per cent over 2023. Wages growth is expected to pick up gradually as the labour market tightens, with the Wage Price Index forecast to increase by 2½ per cent over 2022 and 3 per cent over 2023. The main uncertainties relate to the persistence of the current disruptions to global supply chains and the behaviour of wages at the lowest unemployment rate in decades.

RBA post meeting release, 2 Nov 2021 (my emphasis)

The main points are that underlying inflation at 2.1%yoy remains low, and that the acceleration to 2.5%yoy will take time as wages are expected to accelerate slowly.

This is a theme picked up on in the final two paragraphs (which replace the final paragraph in October). The text emphasizes the low level of inflation, the fact that inflation is lower than in many other countries (and certainly further from target, given that the RBA has a 2.5% target), the modesty of wages growth, and the board’s willingness to be patient.

The Board is committed to maintaining highly supportive monetary conditions to achieve a return to full employment in Australia and inflation consistent with the target. While inflation has picked up, it remains low in underlying terms. Inflation pressures are also less than they are in many other countries, not least because of the only modest wages growth in Australia.

It The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. The central scenario for the economy is that this condition will not be met before 2024.  Meeting this condition This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently. This is likely to take some time. The Board is prepared to be patient, with the central forecast being for underlying inflation to be no higher than 2½ per cent at the end of 2023 and for only a gradual increase in wages growth.

RBA post meeting release, 2 Nov 2021 (new is blue, old is red)

In the press conference Gov Lowe said that it’s still plausible that the cash rate won’t rise until after the maturity of the April 2024 bond. Though he said that it’s also possible that the first hike is before 2024. Gov Lowe emphasized that the dumping of the YCC target isn’t a forecast that the cash rate will rise before 2024. Finally, Gov Lowe said forcefully that the conditions for a hike in 2022 were not in place (at least in these forecasts).

The change to YCC was about uncertainty. It’s plausible that the cash rate might increase before April 2024, so it made sense to discontinue the target.

Finally, Lowe added that the April 2024 would be added to the regular QE program, and that the QE program would continue at 4bn per week until the February 2022 review. I expect them to taper to 2bn per week at that meeting.

Looking forward, the risk relative to market pricing is that wages remain low, as high participation and an increase of inbound immigration increases labour supply. Increased international travel is also likely to take some money out of the home-rennovation sector.

This would extend the period of low wages and low rates. On this topic, Gov Lowe said that he thinks the factors keeping wages down are pretty strong.

Finally, the large increase in borrowing, particularly by first home buyers, may make it hard to get the cash rate up. The Saunders and Tulip model (RBA RDP 2019-01) suggests that a 100bps increase in the cash rate would reduce real house prices by 30% (this seems too large, but I’m sure the sign is correct). First home buyers, who stretched to get into the housing market in 2020/21, encouraged by low rates and incentives, would be significantly hurt by falling house prices.

History shows that the RBA tends to move the cash rate in the same direction as house prices — so unless we have fantastic wages growth, it’s very hard to see 200bps of cash rate increases.

What’s the trade? Rec 5y5y either outright or xmkt v. USD

It’s hard to trust the RBA following the unexpected dumping of YCC on the CPI print, so I am cautious about the short end. I do think the short end is fully priced; but I’m cautious. The trade I prefer is at the long end. I think there’s value in AUD 5y5y at 2.6%, or xmkt v. USD at ~70bps. The logic being that the terminal rate implied by the market is too high.

The chart below shows OIS (from BBG, so it’s bit wobbly) against the RBA’s MARTIN policy rule (and my adjustment) using the RBA’s November forecasts for core inflation and unemployment.

The market has about 25bps too much priced in if we use the forecasts without any adjustment for the RBA’s promise not to hike until core inflation is around 2.5%yoy. It’s 100bps too high if you believe both the RBA’s forecasts and that they’ll keep their word on the lift-off conditions. The market is skeptical, but the RBA’s word is trading cheap just now, so it may be a good time to take the other side.

The other thing to notice is that the long dated OIS continues to converge to 2.25%. Consistent with this, 5y5y OIS remains around 2.25%.

We see much the same thing in the swap space, with 5y5y IRS now a little over 2.6%. Given that the RBA is going to hold onto their bond portfolio until the bonds mature, excess liquidity will remain high for some time. So I struggle to see 6m FRA/OIS above 25bps. It follows that AUD 5y5y IRS at 2.6% seems a bit high.

AUD 5y5y also seems a bit high against the US (the Au/US 5y5y spread). The spike today has taken the 5y5y spread to ~70bps. The Au/US spread is now at levels last seen in 2017 — and moreover, levels that held in the COVID and Q1’21 spikes.

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