Reserve Bank of Australia – Uncharted territory for unattainable goals
3 October 2019
Aidan Shevlin, CFA
Head of Asia Pacific Liquidity Fund Management
J.P. Morgan Asset Management
At the beginning of October, the Reserve Bank of Australia (RBA) cut its overnight cash rate by 25bps to a new record low (Exhibit 1a). The third rate cut in five months has effectively halved the central bank’s key policy rate – leaving the RBA in uncharted territory and one step closer to unconventional monetary policy to achieve potentially unattainable employment and inflation goals. The current trajectory of cash rates will have significant and far-reaching implications for local currency cash investors.
Optimistic rate cuts
In recent speeches, RBA governor Philip Lowe struck an upbeat tone, noting the economy had reached a “gentle turning point”1 helped by a combination of low interest rates, tax cuts, lower currency, infrastructure spending and housing market stabilization.
Despite this professed optimism, the RBA still cut rates in October and remained dovish, committed to “ease monetary further if need to support sustainable growth in the economy, full employment and the achievement of the inflation target”2. However, given current lack of macroeconomic drivers to achieve the central banks full inflation of 4.5% was last reached in 2008 and core inflation target of ≥2% (Exhibit 1b), the probability of attaining either goal remains remote.
The reality is more nuanced: While Australia is currently in its 28th year of economic expansion, gross domestic product (GDP) growth has slowed to a decade low; moreover the rising participation rate is offsetting almost 2-years of positive jobs creation and despite the recent recovery, housing prices have fallen below their long-term trend. Meanwhile, the long term slowdown and rebalancing of the Chinese economy will eventually weigh on exports – although short-term Chinese infrastructure stimulus will benefit Australia’s commodity driven economy.
Sluggish consumption and structural trends
Apart from weak global growth, the RBA’s other key domestic concern remains the lack of growth in domestic consumption – especially during a period of rising employment. However, this can partly be explained by job insecurity, muted wage growth and the high level of consumer indebtedness (Exhibit 2a). All these factors should still benefit from lower interest rates – suggesting that monetary policy remains an effective policy tool – provided commercial banks pass the rate reductions on to consumers.
Interestingly, for the first time, the RBA alluded to a new rationale for the latest rate cut. The structural shifts in global interest rates (Exhibit 2b) – which have fallen to record lows have also placed downward pressure on Australian interest rates. The central bank fears if it ignored the actions of major central banks, the “exchange rate would appreciate, which in the current environment would be unhelpful on terms of achieving both the inflation target and full employment”3.
The implications of sustain lower interest rates
The recent rate cuts, fiscal stimulus and continued Chinese commodities demand, suggest the modest Australian economic recovery is likely to endure. However, growing expectations of additional monetary policy easing by major central banks may force additional, unnecessary RBA rate cuts and even trigger unconventional monetary policy to restrain unwanted capital inflows and AUD appreciation.
For Australian cash investors who are more familiar with high interest rates, steep yield curves and competitive deposit rates, the prospect of extremely low or even zero yields represents a significant challenge. These difficulties have been compounded by the Royal Commissions impact on commercial banks demand for deposits and the Australian Prudential Regulatory Authority’s (APRA) clarification on the definition of cash.
Nevertheless there are several techniques developed and refined during the past decade of zero US interest rates which should help Australian corporate treasurers mitigate some of these complications. These include diversifying beyond deposits into money market funds and ultra-short duration funds, segmenting cash by liquidity requirements and identifying sectors and tenors that offer additional return for minimal reductions in liquidity and security.
Although combining these three techniques will not fully offset the negative impact of RBA rate cuts on cash returns, they will allow treasurers to achieve a competitive return consistent with the objectives of capital preservation and maintaining a high degree of liquidity.
To read more our liquidity insights, visit www.jpmgloballiquidity.com
Defining cash for Australian investors
The definition of cash, while ostensibly straightforward – banknotes and coins – becomes increasingly challenging when the demands for higher returns counteracts the obligation to ensure adequate liquidity and the commitment to avoid losses.
As memories of the liquidity stress and market dislocation triggered by the global financial crisis faded, the range of financial instruments deemed acceptable in Australian cash products broadened dramatically. This was also a time when investors grappled with the challenges of outperforming attractive headline retail bank deposit rates.
Unfortunately, defining which instruments are truly cash equivalents is one of the most difficult tasks for modern corporate treasurers.
The Regulatory Dilemma
Globally, cash investors look to regulators and rating agencies to define and clarify suitable cash investment instruments and structures. This is especially true in the United States, European Union, and China, where the size and systemic importance of liquidity and money market funds (MMFs) made this a critical regulatory issue following the 2008 financial crisis.
These rules and regulations vary from prescriptive, listing specific approved and unapproved instruments, to abstract, outlining key sources of investment risk and limits to mitigate them. Regardless of the regulator’s philosophy, the ultimate goals remain the same – to ensure adequate liquidity and minimise the probability of losses. Over the past decade, global regulators have strengthened MMF guidelines. They now demand higher levels of liquidity, impose tighter investment limits and require increased diversification. For both retail and institutional investors, these new rules have raised the standard of MMF investing while significantly reduced the likelihood of funds suffering losses, albeit at the expense of lower potential returns.
In contrast to detailed global standards, Australian regulators have historically demurred the responsibility to define cash or the suitability of various instruments for cash investments. The Federal government’s unlimited bank guarantee during the Global Financial Crisis helped shelter the local financial industry while a long history of self-regulation encouraged investors to create their own definitions of cash and cash equivalents.
However, in 2018, a review of cash investment products by the Australian Prudential Regulation Authority (APRA) raised significant concerns about the level of volatility and risk in these products. Across the industry, the range of instruments and structures defined as cash varied enormously – as did returns. This created confusion for retail and institutional investors. In its subsequent report, APRA highlighted “examples in the industry where cash investment options appear to include exposure to underlying investments that would not generally be considered cash or cash-like in nature”1.
To encourage investment consistency and reduce the volatility of cash investment products, APRA concluded that “cash equivalents represent short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value”1.
Cash means security, liquidity and return
The report signalled a tougher regulatory stance and additional focus on questionable cash investments styles. However, in the absence of detailed regulatory guidelines and exact definition of liquidity and risk, investor due diligence is still required to balance the need to preserving capital, while ensuring suitable levels of liquidity and maximising returns.
Three key steps in this process involve clarifying investment policies, creating well defined investment objectives and implementing cash segmentation.
Firstly, using an investment policy statement forms a solid foundation for cash investment decisions. A well written policy provides clarity, instils discipline and allows the organisation to successfully navigate shifting markets, changing regulations and evolving business needs.
Secondly, by defining short term investment objectives and the strategies for achieving them, an organisation can establish acceptable levels of risk, identify permissible investments and detail relevant constraints.
Finally, by putting cash into different segments, the organisation can optimise its investment choices – ensuring it has sufficient liquid cash to meet its daily needs while avoiding the opportunity costs associated with very high levels of liquidity and principal protection by diversifying across different types of cash investment depending on their level of liquidity, volatility, and diversification.
The new APRA definition of cash has already prompted a significant reorganisation across the Australian cash management industry with several instrument structures being avoided and more conservative investment guidelines introduced. This, combined with more due diligence and understanding of the underlying risks by retail and institutional investors, should help the industry create a safer foundation for future growth.
To read more our liquidity insights, visit www.jpmgloballiquidity.com
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The RBA’s 50/50 Conundrum
The Reserve Bank of Australia’s (RBA’s) overnight cash rate has been unchanged at a record low of 1.50% for a record 28-months (Exhibit 1A). Throughout 2018, the central bank’s meeting minutes and speeches suggested that rates remained appropriate — implying a broadly neutral policy stance — while hinting that the next rate movement would be higher, albeit with “no strong case for a near- term adjustment in monetary policy”(1) .
For most of 2018, forwards markets agreed with the central bank and were firmly pricing in future RBA rate hikes — but this has abruptly changed (Exhibit 1B) with the market now indicating a 50/50 chance of a rate cut in 2019. This rapid reversal could exert substantial influence on the central banks thinking with significant implications for money market and fixed income investors.
Stuttering growth engines
Historically, Australia’s twin engine economy has been a source of strength, with the combination of commodity exports and domestic demand helping the country avoid recession for a record-breaking 27-years. In the past half-decade, as mining infrastructure investment waned, a booming housing market — with prices jumping by 45% between 2012 and 2017 – replaced it as the key driver of economic growth.
However, the factors that triggered the housing surge — low interest rates, easy bank financing, limited supply and strong foreign demand have recently faded due to a combination of new macro prudential measures, higher commercial bank mortgage rates and tighter restrictions on foreign buyers. House prices (Exhibit 2A), building permits and new home sales have all fallen sharply, with negative repercussions for retail sales and consumer confidence.
Meanwhile, the well-publicized slowdown in Chinese economic growth and rising global trade tensions have raised the specter of lower demand for key Australian commodity exports including coal, gas and iron ore.
Consequences and conundrums
Throughout 2018, solid business sentiment, an improvement in capital expenditure intentions and a tight labor market — with strong hiring momentum and an up-tick in
The path of least resistance
Economic growth will likely slow in 2019, albeit from a previously robust level. However, fears of a property price crash are likely overdone: Low unemployment and low-interest rates suggest mortgage payments remain affordable and most homeowners still enjoy positive equity. Little mortgage borrowing was completed at the peak which was perceived by many as unsustainable.
Finally, even if the economy slowed faster than expected, the RBA has capacity to cut base rates if necessary and the government’s improved fiscal position has given it the ability to cut taxes or boost spending if required.
Given this backdrop, the RBA is likely to strike a more neutral tone in meeting minutes and revise down its 2019 GDP forecast while keeping base rates unchanged for the foreseeable future — further extending its record-breaking period of inertia.
For cash investors, this suggests that money market yield curves could flatten further, although the recent tight liquidity conditions represent an excellent opportunity to extend duration and lock in attractive longer tenor yields.
To read more our liquidity insights, visit www.jpmgloballiquidity.com.
(1) Reserve Bank of Australia’s December monetary policy meeting minutes as at 18th Dec 2018
(2) Source: Reserve Bank of Australia Statement On Monetary Policy, 9th Nov 2018
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