Australian market continues to orbit the RBA’s sun

KangaNews hosted its annual roundtable discussion for Australia’s leading bank fixed-income strategists in February – just as a new round of market speculation on the path of Reserve Bank of Australia stimulus was kicking off. The strategists remain convinced that Australian QE is set for some time, however – and that the market will continue to revolve around the gravitational pull of the central bank.

  • Ken Crompton Senior Fixed Income Strategist NATIONAL AUSTRALIA BANK
  • Damien McColough Head of Australian Dollar Rates Strategy WESTPAC INSTITUTIONAL BANK
  • David Plank Head of Australian Economics ANZ
  • Martin Whetton Executive Director and Head of Bond and Interest Rate Strategy COMMONWEALTH BANK OF AUSTRALIA
  • Laurence Davison Head of Content KANGANEWS
  • Chris Rich Staff Writer KANGANEWS

Rich Economic data are all pointing to a solid rebound in the domestic economy. How confident should we be of a smooth path out of the COVID-19 economic crisis?

MCCOLOUGH I am pretty confident. Our growth forecast is 4 per cent for 2021 then 3 per cent next year. This is based on how consumers respond to the removal of JobKeeper and other support measures.

Consumers are in a strong position to respond given the current savings ratio. This is the major component – along with housing, which is on a tear at the moment – and it should be very supportive throughout 2021.

Our unemployment and inflation forecasts are not significantly different from what the RBA [Reserve Bank of Australia] has in place for 2021. These rest on the basis of a vaccine rollout proceeding without many hiccups. This has already not started as quickly as we thought it might but we will know more about progress quite soon.

PLANK We also have a positive outlook for this year and next, although the starting point is well below the pre-COVID-19 level of GDP. Similar to the RBA, we think GDP will return to its pre-COVID-19 level in Q3 2021. It could be earlier, given the positive surprise in Q4 GDP.

Most core outlooks are pretty similar so the key question really is the risks. There are substantial positive risks, like a downside to unemployment. ANZ job ads data and the NAB [National Australia Bank] survey both point to the possibility that unemployment could fall to less than 6 per cent in the first half of this year, which would be well ahead of forecasts.

The end of JobKeeper will have some impact, which is why we are not as optimistic on unemployment as some of the leading indicators suggest. We have fingers crossed that the picture improves more quickly, though.

The next questions will be about what happens to policy. We have seen the RBA give some mixed messages on this front. It signalled some policy tightening in the first week of February – but just a few sentences after saying it was too early to consider tightening policy.

Even if we get unemployment below 6 per cent ahead of expectations, I think the cash rate will remain on hold given lagging wages and the need for the unemployment rate to be lower still. The RBA is signalling that it could tighten other aspects of its policy, though.

“We are starting to see the government think about the need for ongoing fiscal support. Its recent messaging is that it is focused on the cost of debt, so it strikes me that the government is positioning itself for the next stage. This is well ahead of what it indicated in the budget last year.”

CROMPTON We are reasonably confident in the recovery this year, underpinned to a large extent by the positive signs in the labour market. Our forecast for year-end unemployment is 5.7 per cent. Our macroeconomics team is particularly encouraged by the extent to which hours worked and job ads have been strong from late last year onwards, particularly since the end of the Victorian lockdown. We have similar growth numbers to everyone else: around 4 per cent in 2021 and 2 per cent in 2022.

The RBA’s decision to extend QE was a surprise to our house view but the risk was always that QE would be extended rather than tapered even a tiny bit. The way we have taken this message is that QE is now largely determined by offshore central-bank actions rather than domestic outcomes. The RBA has backed away from talking about QE in the context of the unemployment rate, for instance.

It will be interesting to see how the roll of the yield-curve target is managed. The RBA wants to ensure the market does not get carried away with pricing this year.

The macro risks arguably are more likely to come next year, given the timeline for managing the reopening of international borders. Public attitude will need to adjust to this because clearly at the moment people are jumpy about COVID-19 coming in from overseas. How this evolves in a vaccinated world will be interesting.

WHETTON We expected the RBA to revise its numbers in February, which it did. We thought it was a bit conservative in unemployment and growth. We are looking for 4.2 per cent growth in 2021 and 4 per cent in 2022.

We agree that the QE programme is driven by the expansion of central-bank balance sheets offshore. An extended period of weakness will play into the RBA’s decision on how to slow down stop QE.

We see some risk that the RBA goes for a third QE programme. We are not sure whether this would involve a shift in the mix of government and semi-government bonds or in where the RBA buys on the curve, though. In a speech last year, RBA governor [Philip] Lowe noted the relative spread of 10-year bonds. While this is not a benchmark for borrowers it is meaningful for Australian capital flows.

Domestically, the numbers we see on CBA [Commonwealth Bank of Australia]’s lending book are encouraging. These are faster than system growth, and broadly we are seeing strong consumer lending. Business lending is still quite weak and remains a risk for the economy if it does not pick up.

Wages and salaries going into CBA bank accounts cover around 35 per cent of wages in Australia. These numbers are growing steadily even with fewer people on JobSeeker and JobKeeper. This is a good sign for how the economy is faring in real time.

“We are hopeful that the record Japanese demand we saw last year, of around A$50 billion, can be sustained this year – particularly because we have the highest fixed-rate curve in the G10. Australia is an attractive place for hedged offshore investors.”

Rich Last year was characterised by a lot of risk variability. To what degree are potential outbreaks of COVID-19 still causing uncertainty?

MCCOLOUGH Relatively light-handed measures, whenever they have been needed, along with quarantine measures have prevented any serious spread of COVID-19 in recent months. We have learned a lot of lessons and as a result we are not particularly concerned about the pandemic having a major negative influence in 2021.

CROMPTON We are hoping lessons have been learned during and since the big outbreak in Victoria last year. States now seem to be relying on short, sharp lockdowns that prevent widespread outbreak. We do not have allowances in our forecast for another one so it would be a risk to our forecast if it were to happen.

The evolving nature of policy response will be important over the next year, especially once international borders open. Attitudes may need to change but vaccines will help with this. Our assumption is that reopening goes smoothly, underpinned by vaccine rollouts.

This is a significant assumption built into our forecast. But health assumptions are critical given the extent to which stimulus and support factors helped the economy get through the last year.

PLANK The nature of economic forecasting is that events like a pandemic or a flood can only be assumed to happen or not happen. We cannot assume half a pandemic or half a lockdown.

The market reflects expected outcomes for things like interest rates, so it can be partially priced for the chance of a lockdown. This is the key difference between economic forecasting and how a strategist might assess things.

MCCOLOUGH One major downside risk is fiscal policy. We are coming to the end of some of the government’s support packages and everyone will be closely watching what happens in the May budget – which is also potentially an election budget. It is hard to calibrate what this might mean for economic forecasts because there is also plenty of support coming on the monetary side.

PLANK From a credit perspective, we can ask what might happen if there is another economic hit and whether fiscal policy will respond. We are starting to see the government think about the need for ongoing fiscal support. Its recent messaging is that it is focused on the cost of debt, so it strikes me that the government is positioning itself for the next stage. This is well ahead of what it indicated in the budget last year.

WHETTON Another significant downside risk is further escalation of Australia-China trade tensions. Right now, there is a huge tailwind for the Australian economy from iron-ore sales as China looks to stimulate its economy. This has been very helpful for Australia and, for now, it is an undamaged part of the relationship. If things change, either through tariffs or even just if China slows its purchases of Australian iron ore, it will create a headwind.

“I am okay with the break-even inflation level at the moment because I think we are a long way from inflation expectations getting out of control. Linking this to yield-curve steepness, it seems inevitable that the curve will remain steep – and could become steeper.”


Rich The talk about a quicker-than-expected rebound seems to gloss over that the Australian economy was underperforming prior to the pandemic, with chronically weak wage growth, low inflation and spare capacity in the labour market the main issues. Fiscal and monetary stimulus has been overlaid on these challenges but in response to a different problem – the impact of the pandemic. Does stimulus help or hinder response to the longer-term challenges?

PLANK I think wages will be slow to respond even if unemployment falls faster than forecast because of the factors already in place, such as public-sector wage caps.

One thing that is unclear is the extent to which closed borders mean better outcomes in the labour market, which could lead to wage pressure emerging faster. The release valve of immigration is not there, so we could see a higher wage outcome.

For years, the conventional wisdom has been that high immigration does not depress wages because it creates both demand and supply. It could lead to an interesting policy challenge over the next couple of years if this turns out to have been wrong. This said, we still think material wage rises are a long way off even though we think the unemployment rate will come down faster than forecast.

MCCOLOUGH I agree. The RBA governor has mentioned that 3.5-4 per cent wage growth would be necessary to get inflation sustainably into the 2-3 per cent target band. It has been a long time since we saw numbers like these and I do not think the pandemic will have made many of the drivers of low wage growth, such as technology, go away.

But there is a view, particularly among the states, that the pandemic could be an opportunity for an economic reset. States have blown out fiscal spending with temporary and targeted stimulus, and then in the next couple of years there are a lot of infrastructure and other reforms to come. New South Wales is talking about land-tax reform, for instance. There are nascent signs of a shift relative to the pre-pandemic economy.

CROMPTON There has also been discussion about the utility of writing cheques versus investment – this has come to the forefront particularly with the proposed US fiscal-stimulus package. In Australia, the states were already leading on infrastructure investment and have further expanded capex plans during the downturn. Hopefully, this has a longer-run impact.

Wage growth will be the key. When we were plumbing the depths trying to find NAIRU [nonaccelerating inflation rate of unemployment] a couple of years ago, we discovered it was lower than where we were even at sub-5 per cent unemployment.

The RBA has flagged that NAIRU tends to rise during a recession, but the nature of this recession – specifically a mandated pausing of activity rather than a natural slowdown – means NAIRU may not have risen as it otherwise would. Perhaps we need to get to near 4 per cent unemployment to find it.

“The evolving nature of policy response will be important over the next year, especially once international borders open. Attitudes may need to change but vaccines will help with this. Our assumption is that reopening goes smoothly, underpinned by vaccine rollouts.”

Davison The housing market is a focal point of the way the pandemic and the stimulus response have further entrenched economic inequality. The RBA seems comfortable that housing-market growth is a positive consequence of stimulus, but are there reasons to worry about the housing market growing well ahead of economic fundamentals and, in particular, wages?

PLANK The RBA views housing as a critical part of monetary-policy transmission. It is probably the cleanest one it has, and it always works. One of the reasons core inflation was subdued for the last couple of years was that house prices were weak – which fed into construction and other costs. A stronger housing market inevitably flows into higher inflation.

I think we are a reasonable way from house-price growth being too much of a good thing. It will probably get there, but it will be more of an issue next year.

APRA [the Australian Prudential Regulation Authority] may become more concerned later this year as we inevitably see increasing credit growth. It could even reintroduce macroprudential policy before the end of 2021 given how strong the housing market is.

WHETTON We are bullish on the outlook for housing. The construction sector creates a lot of jobs and this is an easy way to get impact from monetary policy. The biggest factor for house prices is low interest rates. The fact that banks are lending at less than 2 per cent for 3-4 years will encourage a lot of new homeowners to buy and existing homeowners to trade up.

Working from home is a big change that contributes to this, and renovations are also important for the same reason. People are not going back to the office full time and some are not going back at all, so they will be less tolerant of small annoyances at home. They will spend money to renovate if they can.

We are hearing of big increases in input prices such as steel and concrete. This could lead to some inflation, which will be a conundrum for the RBA. But it will probably not be a genuine problem until next year.

Overall, we think the RBA will be okay with rising house prices. It prefaced questions on the subject in the February monetary-policy statement by noting that house prices had not risen for a couple of years prior to the pandemic.


Davison The RBA’s intervention was initially more about providing confidence to the market than direct stimulus. It then evolved to Ôpure’ QE over the course of 2020. What is the relative importance of the backstop-bid aspect versus the straightforward volume of RBA purchases?

WHETTON The message has evolved over time. The RBA’s focus initially was on illiquidity in the market and the inability of banks to warehouse risk. It has moved to influencing lower rates relative to other countries and reducing the cost of funding for businesses and households, to create employment.

The relative rates story is certainly more of a factor now, with the focus being on making sure the currency does not rise as fast as others relative to the US dollar.

The liquidity story is less of an issue now, particularly with the reduction to the CLF [committed liquidity facility]. The market can take down A$20 billion (US$15.6 billion) at a time from the AOFM [Australian Office of Financial Management] without any bumps. The confidence factor is still important, though – which is why the signalling of a low cash rate for the years ahead has remained.

PLANK I do not think the RBA had to do yield-curve control (YCC). We said at the time it was implemented that it would not be sustainable. The objective of central-bank bond purchases should not be to buy as few as possible – it should be to use the balance sheet to force investors to buy other assets. I think it took the RBA too long to realise this.

The key policy at the front end was the TFF [term-funding facility] and in fact if the RBA had initially implemented QE with the TFF we would have had the same outcome we have now. The TFF was the critical policy. I do not think YCC has had much impact other than being a useful signalling device.

The power of the TFF was twofold. It provided certainty of three-year funding cost and levelled the playing field for banks. The latter has been an important dynamic for driving down fixed-rate mortgages and is leading to a transformation of mortgage stock in Australia.

CROMPTON The RBA’s initial buying was particularly important for confidence in the semi-government space. The price widening and volatility in semi-government spreads was nothing like previous shocks. Over time, banks have needed to buy semis for HQLA [high-quality liquid asset] requirements and there has been plenty of demand as a result. But the RBA buying certainly helped the market function in the early phase.

With the broader QE programme, I am not sure how much marginal value is added by crunching 10-year spreads into single digits. Continued buying is helping keep spreads tight and knowing there is a backstop bid is a big confidence booster for investors, though.

Assessing the efficacy of the TFF

The Reserve Bank of Australia (RBA) introduced its term-funding facility (TFF) to support credit provision in the local economy by underwriting bank funding at a low, fixed rate. Strategists say the facility has worked – but its planned June withdrawal may be coming too soon.

DAVISON Has the TFF worked as it was intended to and is withdrawal in June the right decision from the RBA?

PLANK I think it has worked very well. The unstated key aspect is the competitiveness it brought to lending via a level playing field for all banks. This has been a powerful force at the front end of the curve and for the pricing of mortgages. We will see whether the timing of its removal is right. I was surprised that the RBA is prepared to dump it completely in June – I thought it might be tapered in some way.

CROMPTON The nature of the banks’ use of the TFF has been interesting, in that they have only taken down funding at the end of availability periods to preserve options in the near term.

I agree that the levelling of the playing field has been a key factor. The number of fixed-rate mortgages on offer at less than 2 per cent has caused a big increase in refinancing activity, so it is flowing through to household balance sheets.

Davison The YCC aspect of RBA intervention has three-year government-bond yield as its sole target and has thus led to relative curve steepness. Is a steep curve something market participants should assume is baked in for the foreseeable future?

CROMPTON The curve should remain steep for as long as we have the three-year target in place and it remains credible. It has been our view from the start that the RBA’s QE programme will keep the Australia-US bond spread tighter than it otherwise would have been, but it cannot generate a secular rally in Australian rates.

I do not think a 10-year yield curve target would be an achievable goal unless it was set conservatively high. Japan has 10-year YCC but its bond market has a much more domestic focus and the Bank of Japan can therefore more easily control its 10-year rate.

The proportion of offshore investors in the Australian dollar market means the volume of bonds the RBA would need to buy to set a 10-year target last year would have been impractical.

I agree that it would have been preferable to see a traditional, volume-based QE programme implemented early on and across a broader part of the curve. With YCC, the RBA was limited to a three-year target.

WHETTON Australia is a floating-rate, rather than fixed-rate, market for most corporate and household liabilities – so keeping the three-year point is probably more important than focusing on a 10-year point.

“Hopefully by the end of this year the world is seeing interest-rate hikes on the horizon. The RBA does not want the market to get ahead of this, though – so I think it will stress the point that its focus is on actual inflation prints.”

PLANK The biggest problem with YCC is the exit strategy. Every day the RBA has to maintain the credibility of the target, whereas it does not have this problem with pure QE.

When it started to look like the RBA was going to introduce YCC, at the start of the crisis, we thought it would only do so at the front end – because the exit problem further out on the curve is enormous. Yield at 10 years is more sensitive to the Fed [US Federal Reserve] than it is to the RBA.

The RBA still has an exit problem, though. We think it will shorten duration by simply not rolling the yield-curve target to the next bond. We think this will happen in August. Even if it does choose to roll to the November 2024, we still think ultimately the most elegant way to exit YCC would be to fix it on a particular bond so it expires over time rather than abandoning it altogether.

CROMPTON This is our view too – that the April 2024 target will roll down.

Davison The RBA has indicated it expects the cash rate to be at 0.1 per cent until inflation is sustainably within the target band, which it does not expect to occur until 2024. At the same time, there are increasing rumblings about the potential for inflation to pick up in the near or medium term. What are strategists’ inflation forecasts?

MCCOLOUGH As we all mentioned earlier, wages will be the key component of this and I am sceptical about wage growth increasing quickly. Our forecast is for inflation to remain below the target band through 2021, at around 0.9 per cent, before increasing to around 2 per cent next year.

The governor has spoken about being reactive to inflation when it is sustained within the 2-3 per cent band rather than being pre-emptive based on inflation forecasts. We are probably 3-4 years away from this, which is the message coming from the RBA as well.

It will be interesting to see how the market prices inflation. I am okay with the break-even inflation level at the moment because I think we are a long way from inflation expectations getting out of control. Linking this to yield-curve steepness, it seems inevitable that the curve will remain steep – and could become steeper.

CROMPTON In market terms, the 10-year breakeven rate is priced at around 1.9 per cent. I have a recommendation that is long on this, but it is more from a conviction around higher nominal yield causing the breakeven rate to move higher than a breakout in inflation.

The divergence of views on inflation in our recent offshore client marketing has been amazing. Most believe the problems of low inflation that were plaguing the world a couple of years ago are still present. However, some think the massive amounts of fiscal stimulus and pent-up savings from the past year will be released quickly once the world reopens.

I think normalisation could be slower than expected. The release of savings could be a short-term inflationary impulse but ultimately the long-term downward forces on inflation are still there.

Davison Does this suggest we may see some volatility between inflation prints but that overall the RBA will wait to be sure of a clear upward trend and could even focus more on wages than CPI?

CROMPTON I am not sure it will look more at wages than CPI. But hopefully by the end of this year the world is seeing interest-rate hikes on the horizon. The RBA does not want the market to get ahead of this, though – so I think it will stress the point that its focus is on actual inflation prints.

This is a big change from a few years ago, when the RBA giving a medium-term forecast of 2-2.5 per cent inflation would have been a signal that it would move soon. It now wants to move the market away from this mindset, and I think YCC is part of this.

PLANK The problem the RBA has is that it is using forecasts to guide other aspects of its policy, in particular the YCC target and forward guidance. The reason these have changed and created confused messaging is because of the RBA’s own forecasts. These forecasts matter because they influence the RBA’s confidence in forward guidance and its thinking around YCC.

As an aside, the RBA will have an interesting communication problem in the middle of this year when headline inflation jumps above 3 per cent and potentially above 3.5 per cent – but just as a short-term effect.

“I think we are a reasonable way from house-price growth being too much of a good thing. It will probably get there, but it will be more of an issue next year. APRA may become more concerned later this year as we inevitably see increasing credit growth. It could even reintroduce macroprudential policy.”

Davison What tapering of the RBA’s market-support measures should we expect in 2021, and when and how will it come?

WHETTON The TFF will go in June as scheduled. YCC will possibly remain but the market is not testing this at the moment – the question really is around whether the April 2024 bond target rolls on to the November 2024. The RBA has not made a final decision on this.

We have held the view since November 2020 that YCC will go in 2021. After the RBA’s February meeting we firmed on August as the most likely month for this decision.

The bond-purchase programme will move into QE2 and potentially into a third programme depending on the shape of the curve and the need for it, relative to other central banks’ programmes.

MCCOLOUGH We think there is a chance the TFF gets extended beyond June but is recrafted to focus on business credit. This is not an official forecast but we think it could be on the agenda. We see QE3 on the horizon and the removal of YCC to become a focus next year rather than any time in 2021.

PLANK The TFF decision announced in February surprised me as a tightening signal at odds with some of the other decisions. I had been thinking similarly to Damien McColough: that the TFF may be modified. Given what the RBA has now said, I think it will end.

On YCC, our view since January has been that by the time of the August meeting the RBA will have a 2 per cent inflation forecast for the end of 2023 – and as a consequence will not roll YCC to the November 2024 bond. I do not think the RBA will drop YCC completely because it is also providing signalling for the cash rate, but I think it will be kept on the April 2024.

On QE, I think it depends on what other central banks are doing. If other central banks begin tapering the RBA will follow, and likewise it will maintain QE while other central banks are using it.

CROMPTON We have a similar forecast. We think the TFF will roll off as expected. The RBA will need to decide on moving YCC to the November 2024 but we also expect it will not do so.

There was one slight change in the RBA’s language in February that we thought was at least moderately significant. This was that rather than saying the cash rate being on hold for at least three years it is now on hold until at least 2024. At the moment this is the same thing, but it indicates that the three years has now started. This signals that YCC moving to the next bond is not automatic.

For QE, the RBA believes it has been effective so far – equal to around 30 basis points in the 10-year ACGB [Australian Commonwealth government bond] and 5 per cent in the currency. We do not think the effect has been this large but, if the RBA believes it has been the barrier to lifting, it is dramatically higher than we thought it was prior to the February meeting. We think there will be another A$100 billion of purchases in a QE3 programme.

“We think there is a chance the TFF gets extended beyond June but is recrafted to focus on business credit. This is not an official forecast but we think it could be on the agenda. We see QE3 on the horizon and the removal of YCC to become a focus next year rather than any time in 2021.”


Rich Australia’s major banks have indicated that they are unlikely to revert to the pre-crisis level of senior wholesale funding even after the withdrawal of the TFF. What consequences does this have for the Australian dollar credit market as a whole?

WHETTON The banks will be conscious of being absent for too long lest it lift the cost of their borrowing over time. However, there is now also a rarity value to their names that would offset this. They do not need the money as they are in a very strong position with deposit funding, especially while credit growth remains subdued.

Their absence from the market makes it tougher for investors. Financial credit is typically more than 70 per cent of the local market and it is unlikely that offshore banks will come to market to the same degree they used to. They have been much smaller issuers in Australian dollars in recent years and the cross-currency basis swap is also working against them.

The corporate bond market is not growing much, either, so the overall size of the credit market will be reduced. Investors have the option to go offshore and hedge to Australian dollars if they want to find a larger universe of credit to invest in.

The banks will be in the market for tier-two paper in Australian dollars and foreign currencies, so they will have a presence. There may be some senior bank debt, but the issuers are certainly not in a rush.

MCCOLOUGH When the TFF first came in it was obvious that it would shift the issuance balance away from senior-unsecured funding. This led to a view that there could be more diversity in the market because historically so much credit issuance has been from the major banks.

However, with so much cash around and banks wanting to lend it, most corporates have been able to get attractive funding through bank loans rather than by coming to capital markets.

The market is evolving but the search for yield is still as it was before the pandemic. We have seen transactions such as Columbus Capital’s Triton [residential mortgage-backed securities] deal in February, with pricing at 85 basis points over bank bills. This demonstrates the extent to which the search for yield is on and will remain in place for a while.

I do not think what is happening is a major positive for the Australian credit market. Asset scarcity is a problem for diversity in portfolios but it helps keep credit spreads narrow.

CROMPTON We had seen the classic QE effect even before QE was implemented. The assets that the central bank is buying are typically the first to crunch in, after which everyone buys everything else. This is exacerbated in Australia by the disappearance of supply from the credit market.

The next stage is further tightening in the semi-government market, which now looks stretched. Spreads around 10 years in particular look uneconomic – but demand remains strong due to the lack of options.

This is definitely not positive for the market and the point about corporates also not needing the public market means it is a circular problem. I am not entirely sure what the solution should be, but if investors begin to go offshore it could be interesting for the cross-currency basis.

Davison The lack of major-bank supply into offshore markets has led to a squeeze on Australian dollar basis-swap economics and made Kangaroo issuance difficult to justify for much of the last 12 months. Without major-bank senior supply, the Australian dollar market is therefore likely to be very concentrated in local high-grade issuance. Does this pose any risks for its attractiveness as an investment destination?

CROMPTON It is certainly an interesting change in market dynamics. In the sovereign space, hedged yields are stacking up for Australian dollars. Japanese investors were selling early in the year but according to some accounts this was due to legacy positions and buying has returned.

Part of the RBA’s stated intent with QE is to have a portfolio-rebalancing effect. In other words, if it buys a foreign investor out of an ACGB position and that investor sells the currency and allocates elsewhere, this helps the RBA achieve its currency goals.

The extent to which this is actually what happens is unclear and the dynamic will change over time. But it also puts a cap on how effective QE can be in forcing yield here below US Treasuries.

PLANK The big structural change for Australia over the last few years has been the current account. We are no longer an importer of capital, so other things being equal we would expect smaller capital flows across the board. There can still be large flows because a lot of money is being sent offshore by superannuation funds. But it is a big structural change – and we think the current-account surplus will persist for a few years at least.

WHETTON An investor might buy credit offshore but it will be hedged back at the three- or six-month point rather than necessarily swapped to the full date. It is a rolling hedge and therefore does not lift the term basis market.

While 2020 was the worst year in SSA issuance for a long time it has been much more dynamic so far in 2021. Interestingly, the volume at tenor of 10 years and more is almost equal to the amount that has been issued in the five-year space – the first time this has been the case since 2016.

We are of course early in the year but there is definitely a shift caused by higher yield being attainable further out on the curve. At long tenor, the basis still works for the Washington and European SSA names rom an all-in cost-of-funds perspective.

We are hopeful that the record Japanese demand we saw last year, of around A$50 billion, can be sustained this year – particularly because we have the highest fixed-rate curve in the G10. Australia is an attractive place for hedged offshore investors.

Davison Will the weight of government bond issuance continue to come in longer tenors? If so, will this affect trading liquidity dynamics?

CROMPTON The AOFM has had curve extension underway for a while now and this continued with the new 2051 line established last year. But fresh issuance is still rare beyond the 10-year point.

We have seen signs from the AOFM suggesting that liquidity increases in long-end bonds around the time it does a big transaction. I wonder if this is starting to flag that there may be a more sustained issuance programme into the long end. There is certainly investor demand, mostly from offshore.

At the same time, investors seeking spread pickup in semi-government bonds also need to go beyond the 12-year point. At the moment there is a massive trade-off with liquidity at that point, but this is less of a factor for some offshore investors.

Some of the semi-government borrowers are keen to meet long-end demand. Their challenge internally is a mismatch between the duration of funds their clients want versus the funding levels they can achieve at the long end. I get the impression the semis are keen to meet long-dated demand if they have demand internally.

Davison Is it possible that, over time, we will see supply-starved credit investors migrating to the semi-government space – and potentially thus the development of long-end demand from local investors?

WHETTON I think this would be a stretch. Credit investors would need to get their mandates changed. There is also a whole world of credit out there so investors may just need to be cleverer about buying and hedging it. Alternatively, they can move into the private-credit market.

I think credit investors will remain as such because that is their skill set. The semi-government market is a much lower-beta environment and therefore returns are lower.

Going to the long end is also difficult because it is a specialist market. The reason the semi-governments have never issued much further out on the curve is because Australia is not a long-dated, asset-liability matching market. We have defined-contribution rather than defined-benefit pensions.

In Europe, the US, UK, Japan, Korea and Taiwan, investors have to buy at the long end to match assets. The fact that hedging costs have made it much more attractive means the semi-governments issued more than A$10 billion in 20-30 year tenor from March 2020 onwards. This is far greater than we have ever seen.

But I still cannot see credit investors buying these bonds. They are still not attractive enough as a pick-up relative to the yield offered and investor mandates.

RBA sailing on global currents

The Reserve Bank of Australia (RBA) has some capacity to taper or even withdraw stimulus measures over time. Ultimately, though, it will likely not be able to go fully in one direction if its international counterparts are heading in another.

DAVISON Is Australia essentially locked in to QE stimulus for as long as the bigger offshore central banks are doing it?

MCCOLOUGH If the RBA is targeting the currency the litmus test would be what would happen if QE were removed tomorrow. Given all the other influences on the currency, we know it would move significantly higher. Therefore, the simple answer is yes: the RBA is locked in while the other central banks maintain QE.

We are forecasting tapering in QE3, with purchases down to A$50 billion (US$39.1 billion). However, this has large risks to the upside.

The RBA will be looking at the volume it owns in any individual bond line and whether it is creating bottlenecks or shifting investor behaviour in the market. This is likely to become more of a problem with QE3, if it is indeed extended.

The RBA is talking about owning 20 per cent of the market rather than 40 or 60 per cent. But if bond-purchase programmes are large enough that they take away liquidity, and there is a reliance on the central bank being the backstop bid for extra supply, we may see a dysfunctional market.