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Thursday, September 22, 2011

Is the RBA at loggerheads with the financial markets?

I had a bizarre experience while sitting in my car the other day. I had pulled over in Bligh Street, in Sydney's CBD, and was finishing up a call. In the space of only three minutes, I saw a multi-billionaire plodding up the road, a hedge fund guy worth a couple of hundred million crossing it, another younger fella who runs a Liberal Party think tank, and who will become a Federal Minister one day, going the other way, and, finally, the former leader of the NSW Opposition, who would be Premier today had he avoided certain indiscretions. It was kinda freaky.

Anyhow, it turns out that one of these blokes called me about an hour later and asked me what the RBA had meant by this curious, and market-moving, statement in their Board Minutes (emphasis added):

"Members were informed that, in Australia, market pricing prima facie pointed to expectations of large cuts in the cash rate by the end of the year, but a range of technical factors meant that market pricing might not be giving an accurate reading of expectations in the current circumstances."

The Deputy Governor of the RBA, Ric Battellino, reiterated this view in a speech he gave in New York overnight (emphasis added):

“[F]inancial markets seem to have concluded that the risks are weighted towards the Australian economy weakening sharply and, taken literally, seem to be pricing in a reduction in official interest rates towards the unusually low levels reached after the GFC. There are technical reasons why current market pricing may not be giving an accurate picture of interest rate expectations. Nonetheless, markets do seem to have reached a pessimistic assessment and this appears to be based mainly on the assumption that weakness in the US and Europe will flow through to Australia.

So what gives? Are the RBA and the considerable weight (and knowledge) of financial markets at loggerheads? Yes and no. While the RBA is an economically conservative institution, you tend to find that alumni have a healthy disrespect for the ‘efficient markets’ doctrine, and the sanity of markets more generally. The Lowy Institute’s Stephen Grenville, who was previously Deputy Governor of the Bank, exemplifies this attitude in his writings.

To understand the RBA’s skepticism for markets you need to reflect on its role: the RBA is a non-democratically elected institution that unilaterally sets the price of credit in the economy, and less directly, the price of money. In its own way, the RBA is constantly seeking to ‘correct’ markets and their expectations. Another good example of this is when the RBA (rarely) intervenes in the currency market by buying or selling Australian dollars. It says, quite explicitly, that it only does so when financial markets become disorderly and over- or under-shoot reasonable estimates of fair value. Once again, this is a central bank opining that the markets have got it wrong. Interestingly, the RBA has thus far resisted the temptation to sell Aussie dollars during the recent episode primarily because the appreciation of the currency has only served to validate its medium-term view of the world (and is, to some extent, saving it from having to hike rates).

In responding to my friend’s question about the RBA’s back-hander to the financial markets apropos interest rate expectations, I offered the following explanations.

First, the RBA is very likely subtly pointing out that market pricing for interest rate changes is not a forecast or a prediction, as is commonly believed: it is, more precisely, a 'probability-weighted price'.

Imagine you had three potential contingencies for interest rates over the next year in your mind, and assigned each a probability. The market price would be equivalent to your 'expected value', or your probability-weighted interest rate estimate.

Now, if I asked you to supply a specific prediction, you would nominate your most likely outcome. Note that this will be different to the expected value. It will be especially different if the expected value is being influenced by a reasonable probability around some catastrophic event, as it is today.

For example, you might say that you think in your ‘base-case’ there is a 70% chance rates will stay on hold until December. But then you add the rider that if, say, the Eurozone were to break-up, an event to which you assign a 30% probability, the RBA would be compelled to slash rates by, say, 100 basis points as it did in October 2008.

Observe how this gives you a ‘probability-weighted expectation’ of slightly more than one rate cut by the end of the year (if you multiply 70% by the cash rate and 30% by a 100 basis point lower cash rate), which is markedly divergent to your ‘base-case’ of no-change.

The second thing the RBA is likely canvassing is that the short-end of the yield curve, which people use to infer ‘market forecasts’ for rate changes over the next 1-2 years, is being artificially buoyed by the very high demand for cash (eg, bank bills) and other near-term, liquid securities. In the currently turbulent environment, many institutions, such as banks and pension funds, are parking their money in cash until the dust settles. This demand for cash has the effect of driving up prices and reducing implied yields. The net result is lower interest rate expectations for the period covered by the securities in question.

The other technical distortion we are seeing is in middle (or ‘belly’) and long-ends of the yield curve, which are dominated by the 3 year and 10 year Australian government bond prices. These prices are being artificially boosted for reasons I have explained before: viz., central bank and institutional portfolio diversification of their sovereign investment risks.

As is now well known, Australia is one of the few remaining AAA credits in the world, and has by far the strongest and healthiest balance-sheet of any country in the OECD (including Switzerland). We are pretty much the only developed country that has generated 20 years of uninterrupted growth and avoided recessions during both the 2001 'tech wreck' and the 2007-08 GFC. Furthermore, Australia offers growth diversification away from the North Atlantic economies, which, according to the IMF, account for less than one-third of the global growth pulse. In particular, 65% of Australia’s exports go to developing nations, while 75% go to Asia. The chart from the IMF below shows the expected growth gap between emerging and developed countries over the next two years. Australian investments give you exposure to the top yellow line.

Here is interesting to observe that notwithstanding the extreme media pessimism we are greeted with every day about North America and Europe, the global economy should be chugging along at a trend rate of growth in 2011 and 2012 even assuming very poor conditions in the advanced economies.

Given their high debt-to-GDP ratios, political dysfunctions, ageing populations, and the absence of leverage to emerging economies, many central banks are, at the margin, trying to quite rationally reduce their exposures to the traditional ‘safe haven’ currencies (eg, the US greenback, Yen, Sterling, and Swiss Franc). And since there are few alternatives in view of the pegged Chinese currency, there has been a tremendous increase in the demand for untainted Aussie sovereign debt with the likes of the Russian central bank announcing that they will start buying it for the first time.

Similar logic applies to global fixed-income investors that hold sovereign credits: in the current climate, safe yet high yielding Australian government bonds are at the top of their shopping list. When buying Aussie bonds, you buy Aussie dollars, so this also explains the currency’s (relative) strength.

A related wrinkle here is that many offshore buyers of Aussie government bonds are ‘price indifferent’ because the yields are so high and they can hold these assets ‘to maturity’ on their balance-sheets. That is, central banks don't necessarily need to worry as much about 'mark-to-market' risks.

The rise in the price of Aussie government bonds as a structural artefact of global investor and central bank portfolio diversification has in turn reduced their implied yields (given the actual interest payments on the bonds are fixed). And so longer-term Australian interest rates also appear to be very low, which would normally insinuate dismal growth prospects. This is exactly what has enabled the major banks to cut the cost of their fixed-rate home loans to more than one percentage point below the headline variable rate.

Within the yield curve, the 3 and 10 year government bonds provide the ‘benchmark’ prices. If the 3 year price surges, it will tend to bleed out through the rest of the curve. More specifically, the shorter 1 and 2 year interest rates have very high correlations with 3 year rates. In this way, short-term interest rate expectations can be pushed down further as a technical function of the global appetite for Australian sovereign credit.

Taking all of the above factors together, the RBA is basically saying that market expectations are giving you a bum-steer on the likelihood of rate cuts. Sure, we may get them. But absent a total meltdown, they are unlikely to come as quickly or generously as market prices imply.