ALEXANDER Because of QE, we are now in a situation where the biggest player in the Australian Commonwealth government bond (ACGB) market is the Reserve Bank of Australia (RBA) – and it only buys.

Before QE, if there was substantial flow in a particular bond the market had to deal with it without any help or backstop. Typically, the bond in question would cheapen as a result of the heightened flow. If there was more than enough of a particular bond to go around, it would underperform and we would see some relative value (RV). The RV would then create turnover as market participants traded in and out of the bond.

Now, with the RBA involved, it is much easier to take on any bond because we know the RBA will be there in a couple of days’ time if we need to sell. This certainly changes the market dynamic, and it affects liquidity.

In one sense this is surprising – because theoretically having the RBA as an extra provider of liquidity should make things better. But actually the market loses the natural tension and turnover it gets when it is running independently.

A source of turnover has disappeared and it is difficult for traders to take on new positions without it. We have lost the chicken-and-egg dynamic of turnover leading to more turnover.

Also, some of the opportunities we look for in the search for RV have gone away. This applies to all the ACGBs out to 12 years, the longest bond in the futures basket. Beyond this point, the market is still on its own – but only in the sense that it was never that liquid prior to QE, and it still isn’t. Overall, QE has been bad for liquidity and turnover.

RAVENSCROFT One obvious consequence of RBA intervention is that it has come at the cost of asset valuation. The RBA has entered as a nondiscretionary investor in significant volume. This fundamentally changes valuations, in particular of ACGBs up to the back end of the 10-year basket.

This has changed the way in which users participate in our market. Two-way turnover is still elevated because traders and investors are participating via the process of QE. But funds the RBA puts to work are not being reinvested, so investor flows have become one-directional.

The RBA has provided a backstop to exit risk at relatively low cost, and this has increased liquidity. But on the other side, QE has been detrimental to gathering offshore and domestic interest, and to RV opportunities.

COLOSIMO I agree that it certainly feels like RV opportunities are more limited in government bond markets, and therefore there are fewer opportunities outside of primary. We are even experiencing less activity around primary deals across the market, which would normally generate their own significant secondary-market turnover.

Another issue we have seen, as an asset allocator and a portfolio manager, is that we have never found it more difficult to find a home for cash in this world of abundant liquidity.

YETSENGA The reality is that limiting opportunities in the bond market – and indeed making the market itself less attractive – is one of the intentions of QE in the first place. The policy is designed to direct capital to other parts of the financial universe, and hopefully to other parts of the real economy. Listening to this discussion, this is exactly what I would want to hear if I was a policymaker.

YETSENGA To a certain extent policymakers can only use the tools they have. I suspect even if policymakers think the degree of impact will be less than the theory suggests, they will still do it.

Beyond this, I believe cutting rates and driving down bond-market yield has redirected capital into other parts of the financial-market universe. The policy would be most effective if it redirected capital into other parts of the real economy, though. If the tone of the question has some scepticism underlying it, I think the scepticism is well founded.

MURRAY Being a regulated entity and a liability-driven investor comes with a few unique considerations. We have seen the government bond curve term out, which is good for an investor, like us, with long-term liabilities. This is one of the positives of this environment – we have much greater opportunity to get invested in a way that matches our liability profile.

As for the challenges, until very recently policy initiatives have taken the banks out of the market. They have traditionally been a key sector in the primary market and an important source of RV opportunities.

The other corollary of this is demand for corporate issuance has been huge. Meanwhile, I think corporate borrowers have had less need to access the market. This has created a whole other dynamic.
We find RV with a combination of term premium, illiquidity premium and looking in different pockets of the market where we traditionally have not needed to focus. We have needed to spread the net a bit wider to get value.

For example, we have been looking more at private placements – where we at least get an illiquidity premium. Because we have longer-dated liabilities, we can tolerate a bit of illiquidity in our assets and this has provided us with a few opportunities that perhaps may not be available to other investors.

BARRINGTON This is also a feature of the semi-government market, depending on the liquidity landscape. In 2020, we often saw investors bypass the secondary market and source liquidity directly from issuers via large-scale reverse-enquiry trades.

This reverse-enquiry trend was also evident in the credit market but the focus was more about a search for yield – capturing illiquidity premium – as spreads crunched in. Whereas, in the semi-government space, it wasn’t necessarily about getting a yield pick-up but getting set in the volume investors were after.

BUTCHER We hold semi-government bonds for liquidity purposes, but the game has changed recently. Our capital considerations are quite significant and we therefore have internal limits for duration. We feel quite constrained in this environment.

Having said this, we are reassessing what is happening as a result of the CLF [committed liquidity facility] announcement. Banks will have an incentive to get as many semi-government securities as possible as we move from alternative assets into semi-governments and ACGBs.

COLOSIMO We have been exploring opportunities over recent years to move more into private credit, to gain the illiquidity premium. We are obviously taking on more credit risk to do so. However, as a superannuation fund – and this was borne out during the pandemic – we will always need to own government bonds purely for liquidity purposes. There is a limit to how far we can push down the credit and liquidity curve.

We haven’t necessarily reduced our volume in government bonds. This stems from trying to stick to our process when it comes to RV opportunities. Historically, natural buyers have asserted themselves in various parts of the curve and thus created opportunities in ‘unloved’ sectors, in the hope of revival.
The most obvious case is that basket bonds used to trade significantly richer than non-basket bonds. We have exploited this over time, but we have less opportunity to do so now.

Ultimately, we are trying to stay true to the process. This means we have been taking fewer opportunities and been less aggressive in what we do within our government-bond and liquidity portfolios.

As for offshore investment, I think we need to distinguish between our dual roles as asset allocators versus portfolio managers. As manager of our internal portfolios, we only have mandates to remain within domestic markets.

When we invest offshore, it is typically following the traditional superannuation model as asset allocators – funding external mandates and finding institutional portfolio managers to invest.

To an extent, we have been putting more money offshore – specifically in credit – but we are not necessarily using it as a source of liquidity.

DIAMANT We consistently hear from investors, particularly domestic asset managers, that they need to maintain liquidity – whether in the form of government or semi-government bonds.

However, over the last 12-18 months in particular we have noticed a willingness to look at a wider array of asset types. We can see this in the oversubscription of primary corporate deals in the public market. In 2020, the average coverage ratio of corporate deals in Australia was 3.2 times and in 2021 it is still around 2.4 times.

There is also the heightened level of reverse enquiry we have seen for private transactions, where in some instances liquidity is sacrificed for enhanced spread.

This chase for assets has also been redemption-driven, given the elevated maturity profile in 2021-22. In effect, we are seeing a barbell investment approach adopted by asset managers: maintaining an allocation to high-grade liquid assets, yet to attain a yield buffer also increasingly looking at subordinated debt, mezzanine structured credit and private transactions in rated and unrated formats.

We have also heard that more funds are considering opportunities in the syndicated-loan market. Ultimately, I think there is a greater range of options on the table for fixed-income asset managers.

BARRINGTON The point about the barbell is important. We have seen liquidity drained out of the major-bank sector and accounts moving down the credit curve. At the same time, some investors have moved into government and semi-government bonds to replace liquidity they previously got from major-bank issuance.

This is only going to become more extreme as the CLF is withdrawn. The liquidity we had in 2018 and 2019 will not be there, and this could change domestic investor behaviour and deal sizes.

DIAMANT I think so – and it ties into why we have not seen heightened secondary activity accompanying primary supply. Notably, trade switches ahead of or immediately after primary transactions are suppressed. This is demand-versus-supply dynamics at play, specifically that we have not seen adequate supply relative to bond redemptions for 2021 standing at A$155 billion (US$111.3 billion).

Major-bank issuance in the Australian dollar market is historically pivotal to primary supply, but it has been absent. It is worth noting that, since the CLF announcement, we have seen seven deals from the Australian major banks – including offshore, and across covered, senior-unsecured and funding-only RMBS [residential mortgage-backed securities] formats.

ALEXANDER I think we need to ask questions about the purpose of all this intervention from the RBA. Clearly there was a place for what the reserve bank did when the market was melting down in March and April 2020. There was no liquidity even in mid-curve bonds and futures sold off by 100 basis points. Clearly, market dysfunction needed addressing at that point in time. But it was a while ago and I think the need is now less clear.

There are positive and negative consequences of the intervention. One of the positive consequences is that potentially some capital is directed to other investments. But this has its limits, and it comes with costs.

It is clear that the RBA killed the three-year futures contract, at least for a while, with its yield-curve control policy. It was a game of trading the implied repo on the bond – and because the repo was anywhere down to -100 basis points, it was not very interesting to trade. This took the liquidity out of it, and in fact I am amazed it traded as much as it did during that period.

More recently, everything is now subject to so much liquidity that it makes sense for offshore investors to buy even very rich, short-dated bonds because they will pick up on the basis.

These crazy distortions are occurring throughout the market. They can create some interesting term premia, which is something new and makes the market a bit more interesting. But generally I think we are paying a price for a market that has been pushed too far. We have ended up with a different type of dysfunction from the one the RBA stepped in to address.

RAVENSCROFT I agree. When the RBA initiated QE, it was necessary to settle liquidity conditions that had become incredibly constrained. We have now moved through the journey of QE, where central-bank participation effectively remains similar across the market but the rationale for investors participating in QE has shifted.

At the peak of the crisis, it was an opportunity for investors to de-risk or raise funds in a world where doing so was very challenging. Nowadays, QE provides an opportunity to sell assets at an attractive level that has been set by central-bank intervention. I think the need for QE is now somewhat less.

In Australia, the market assumption is the RBA wants to remain on the defensive side and be accommodative for longer than its global peers. But, with the Fed [US Federal Reserve] recently hastening its progression to the end of its own QE programme, we need to consider that the RBA may have an opportunity to accelerate its own taper process ahead of current domestic-market expectations.

YETSENGA It strikes me that the RBA is not playing to the central case. A lot of the comments about market function are very well made. But the RBA has gone from supporting market function and rescuing an economy that looked like it was in potentially serious strife, to a model that is trying to correct the policy errors of the last cycle.

The deflationary forces in the economy during the last cycle were not anticipated or fully understood and the RBA does not want to make this mistake again. As such, it is playing to the lower bound of its own confidence.

One of the costs could be that if the RBA remains loose until much later in the cycle, it will need to move more abruptly when it tightens. We are in for a different tightening cycle than Australia has seen in the past and it is unlikely to be gentle or smooth.

We are in an unprecedented fiscal position with unprecedented liquidity injections and new liquidity facilities coupled with a new approach to monetary policy. All this is likely to mean that, when the tightening comes, it could be more abrupt than we have seen historically. The next couple of years is going to be interesting – so get your tickets now.

BUTCHER APRA has said the CLF will be zero by the end of 2022 and we will be working on a gradual scenario from now until that point. Our process now is about crunching the numbers to see how this works. In broad terms, we have to switch a portion of what we used to hold for the CLF into buying semi-government and government bonds.

There is a funding implication and a relative spread implication in the amount of assets used as collateral for the CLF. In the case of a mid-sized bank like Suncorp, this effectively means we will be out of bank senior-unsecured bonds and RMBS.

We will be moving from relatively higher-spread to lower-spread products and, at the same time, we are going to have to issue in some shape or form. Elevated exchange settlement (ES) account balances mean the effect of this is less, but it will still be evident.

We are working through this and trying to work out how we go about the transition. The good news is that the savings rate has been high, which is one of the reasons ES balances are so large and bank issuance has not been what it was prior to COVID-19.

The capacity and demand for banks to issue in the wholesale market has probably never been greater, so I don’t think funding will be an issue. Replacing CLF assets is just an additional relative cost and I think, in the short-to-medium term, we will see widening pressure on products like the cross-currency and single-currency basis.

It will also be important to see what happens with the savings rate as we come out of lockdown. We wouldn’t want to have a major problem with the market in the next calendar year, with the CLF withdrawn by the end of 2022 and TFF [term funding facility] debt rolling off from 2023.

On the other hand, it is important to remember that the CLF is not being eradicated, just brought down to zero. It could be used as an emergency liquidity tool – it just won’t be business as usual, given the scale of outstanding issuance by the semi-governments and the government.

I think the banks are well positioned. But there would be more pressure on markets if the savings rate drops dramatically at the same time as TFF maturities and banks having to refinance with a lot more issuance at the same time.

ES balances mean it is certainly manageable, but there will be increased issuance. It will also be interesting to see how the shape of books change as balance-sheet buying of senior-unsecured and RMBS transactions is dramatically reduced.

BUTCHER It is an option, though it depends on our duration profile and there are some risks. There is a price for everything so at some point we would move into ACGBs. But it depends on the underlying shape of the yield curve, too. If ACGBs are trading at zero but we incur some sort of capital cost for duration through IRRBB [interest rate in the banking book] regulation, we would end up better off leaving cash in the ES account anyway.

RAVENSCROFT This will be very topical over the next 12 months as we work through the CLF reduction process in tandem with the QE taper cycle, both of which provide strong tailwinds for semi-government spreads in 2022.

Headwinds for semi-government debt to counter this are supply volume and asset-swap valuations. Semi-government funding programmes dictate net positive supply – unlike the weekly negative supply dynamics seen in ACGBs. Meanwhile, a reduction in the CLF will dictate more asset-swap-based buying in semi-government bonds. This in turn suggests asset-swap spread, rather than a spread to ACGBs – which is more commonly used by offshore investors – is the more relevant valuation for semi-government bonds going into next year.

Semi-government spreads to sovereign bonds have been very volatile over the last quarter. But moves in the swap market over the same period suggest it might be difficult for semi-governments to gravitate back to their cyclical tights as a spread to ACGB.

There remains potential for short-term performance in semi-governments given we are still 5-10 basis points off the cycle tights on an asset-swapped valuation.

On the supply front, consistent volume of issuance will provide some offsetting pressure on spreads, particularly around the 10-year part of the curve. But the market has demonstrated the capacity to absorb large supply and is happy to collect new-issue concessions as they appear.

Semi-governments also have a mix of tools to tackle their funding targets. The FRN [floating-rate note] market, for example, is a great opportunity to access large-scale funding to supplement more traditional issuance avenues.

The story of next year is going to be a combination of these factors. With the end of QE and the reduction of the CLF, the market will have to find real clearing levels for these assets in the absence of the RBA.

YETSENGA The CLF was introduced as an emergency measure and there is more than a year of lead time to winding it down. It is probably not going to be a big deal from a macro perspective.

COLOSIMO I agree with a lot of the points made about the demand and supply impacts on semi-governments, unsecured bank credit and RMBS. One thing to add is there will probably be an increased impetus for banks to try to manage the net-cash outflow measure that is used in the calculation of LCRs [liquidity-coverage ratios] by trying to achieve retail look-through for their institutional deposits or paying more for longer-term deposits.

At the margin, this might slow net-cash outflow growth, allowing banks to manage their LCRs. As a superannuation fund that not only thinks about fixed interest but also how to invest cash, we are watching for this outcome.

ALEXANDER It seems to me, from a slightly removed position, that the CLF was a measure put in place for a particular set of circumstances that no longer prevail. The idea of removing it to go back to normal seems perfectly natural.

The removal could create some interesting opportunities, because the banks will have certain preferences for the semi-governments they need to buy. Primary versus secondary, longer-term versus shorter-term and the term premium could all come into play.

BARRINGTON One of the by-products of the CLF reduction that has not been discussed as much is the impact on the LCR. I think this will have big ramifications for the front end and how the banks structure their liabilities to manage net cash outflows, ultimately leading to further product innovation.

In relation to the impact on government and semi-government markets, it feels like a case of ‘back to the future’. We are re-entering a period where balance sheets are increasing the size of their HQLA [high-quality liquid asset] holdings. Looking at the breakdown of primary books, the long end used to be dominated by balance sheets but, more recently, domestic real money has driven these deals – especially in the 12-15-year part of the curve.

Balance sheets have participated less in the long end due to capital considerations. However, I think this trend might reverse – especially if spreads compress further – and we will start to see balance sheets more active in the long end as semi-government issuers continue to lengthen their benchmark curves.
In relation to credit markets, it will be interesting to see what happens with alternative liquid assets (ALAs) over the next 12 months as banks restructure their portfolios.

BUTCHER We will need to transition our book out of ALAs – senior-unsecured and RMBS – into semi-governments and ACGBs. We don’t want to be the last one in the market selling an ALA and we don’t want to be the last one in the market buying semi-governments.

In other words, even though it is a staged transition and we have some time, the question is still whether we hold these ALAs. We will look at the relative trade off and take all costs into account, rather than just looking at it from a liquidity or collateral perspective.

Spreads probably need to be wider than they are now to make a case for investment because we are comparing liquid assets we are funding against the lending we do – to mums and dads, and businesses. Liquidity is key in this context.

The net cash outflow is critical. The large increase in the savings rate has materially increased the amount of at-call deposits. For banks, these all sit within the 30-day window albeit with a big discount depending on how stable they are regarded by regulators.

It will be interesting to see, as we learn to live in a COVID-19 world, if deposits move out of the 30-day window where we have to hold liquid assets. David Colosimo mentioned the superannuation funds with a retail look through, and all these can move the dial and have implications for the underlying interest-rate market and the basis.

YETSENGA Historical reality clearly shows we don’t forecast transition in the inflation regime well at all. We forecast inflation itself slightly better, but if we are talking about central banks operating policy on a different basis and wanting inflation to run structurally higher than we have been used to in the post-financial-crisis period, the timing of the shift is a very open question.

We can point to a lot of preconditions today that suggest inflation is coming. For instance, our weekly ANZ-Roy Morgan consumer-confidence survey has an inflation expectations measure that is at its highest level since 2014 as of this week’s reading. This is quite important when it is reflected in the CPI inflation that ultimately matters to the RBA.

I am not sure whether there will be a taper tantrum, but central banks have taken liquidity out of markets by the activity of their policy actions. The timing is going to be tough to call because the world is more indebted than it has ever been.

My fervent hope is that the change occurs at a time when governments have moved to more sustainable fiscal positions. If they have not done so, it will be a cocktail we really don’t want to see.

ALEXANDER Central banks want to lift the rate of inflation sustainably to their targets or at least into the band. The RBA has said it needs to see inflation sustainably in the band before it moves policy, and it thinks this will be in 2024.

What I think will be very interesting is how the market anticipates this. At the moment, the market disagrees with the RBA and thinks inflation will happen sooner, including earlier rate hikes.

Part of the problem will be distinguishing what the Fed thinks is transitory inflation and what it thinks is sustainable inflation. I think there is a genuine case for distinguishing between, for example, energy-price inflation – which is quite buoyant in some parts of the world – and wages inflation.

Central banks may be more focused on wages inflation, but at some point lots of one-off transitory inflation will lead to overheating as well. Exactly how the market navigates all this, along with exiting QE, exiting lockdowns and opening international borders will make for an interesting period ahead. There is no question about this.

I agree with Richard Yetsenga’s view that when the rate hike comes, it will need to be abrupt. The reserve bank will hold off and hold off until the pressure is clearly too much and then it will need to slow things down. At this point it will know full well that hiking 25 or 50 basis points won’t do much so it will need to go harder.

The market is used to one level of stability and liquidity, and we saw in February what the market can do when expectations change abruptly. We may have more of this ahead of us.

RAVENSCROFT As market makers, we are constrained in our opportunities for diversification. Instead, the best tool at our disposal is to adapt to a changing environment by changing our trading mentality.

To adapt to more frequent bouts of volatility and poor liquidity conditions, driven by an increasing rate cycle, we will need to shorten our trading horizons and be willing to change our near-term trading view more actively.

We will also have to re-think how we position our books. If we expect the gradual return of greater RV opportunities throughout the year, lighter and more nimble book construction will be prudent to give greater flexibility to take advantage of RV as it presents itself.

I think liquidity provisioning for clients will remain unchanged. We adapt to our clients’ needs and doing so will give us the best insight on how to position our trading books.

MURRAY A lot of things going on in the world are inherently deflationary. Markets have been focused on short-term inflationary impacts, but how quickly these unwind and whether we revert to an environment of lower inflation is a question mark for me.

We still have ageing populations in developed markets, increased penetration of renewables and focus on carbon intensity – which over time reduce the cost of energy and production – and the new normal of working from home with associated uptake in new technology that changes the way we work and travel. All these are somewhat deflationary.

YETSENGA Demographics, globalisation, technology, and debt can certainly all be deflationary. But I think climate change has a different influence. There is an energy-price aspect, but we are also retiring energy assets decades earlier than their useful life. The fact that the world is acting on something with an overt policy push suggests it is a cost to the system. It is certainly a cost in reallocation.

Increasingly, research is suggesting we have been looking in the wrong place for deflationary influences. Data in the US show the differences in saving rates across wealth strata are much larger than the differences in saving rates across demographic strata. Demographics has probably added to the deflationary bias but actually the rise in inequality globally seems to have been a much bigger influence.

I think one of the things that will come out of COVID-19 is much greater focus on distributional issues. Growing the pie is not enough if it is not distributed in a more sustainable way. This plays into a narrative that suggests we are passing through a disinflationary episode into something potentially quite different. If this is right, it has a big implication and correlations will be different.

When inflation is higher, history tells us bond markets and risky asset markets interact in quite different ways. I think this will be quite exciting and am looking forward to it.

ALEXANDER Inflation has for a long period continually surprised on the down side, so we know there are clear deflationary forces that perhaps were not as well understood in the past as they are now. For me, the two main factors are globalisation and technology.

Globalisation is related to the Gini coefficient with wealth and income distribution affected by the decreased bargaining power of workers. This means we just don’t get ongoing wages-generated inflation. Then, as technology improves, certain jobs become marginalised. This again decreases workers’ negotiating power.

COVID-19 lockdowns have improved the uptake of technology. I have heard one analyst describe the COVID-19 experience as compressing five or six years’ of technological uptake into a year or so. This makes a big difference.

Globalisation has probably been put on pause due to travel restrictions, but these deflationary forces are likely to resume and will make it hard for central bankers to get their wish and have inflation back to target.

Distributing the pie better could help. China now has a very specific policy on this, which could be the start of something. But it remains to be seen how easy it is to do. Arguably, you need to shrink the pie in order to slice it up better.

BUTCHER I think this unprecedented stimulus, where everything is turned up to 11, means there will be inflation once most of the population is vaccinated. But structural deflationary forces will come back, too.

It is a bit like going for a swim at the beach. You put your head underwater and swim around, then look up and realise you are miles away from the sand. Then you have to start swimming back. I think term bond yields are in this spot at the moment.

It probably will come in two stages. The bit I am worried about is investors’ level of risk and the way they are positioned. It will test the market if sharp moves like we had in February become the norm.

I also don’t think we can underestimate how much structural positioning takes place to accommodate an ongoing environment of lower rates – the way portfolio and bank balance sheets are managed and their benchmarks. If rates fundamentally change it will have a much larger effect than the actual positioning of the market itself. I think this will be a big factor over the next 12-18 months.

Richard Yetsenga was describing something that is almost a 1994-type scenario. Hopefully, what we experience next is not like that, but when rates were 20 per cent no-one ever thought they would get to zero. Now we are at zero and no-one thinks they will rise significantly. If we can learn something from history it is, in my opinion, that things will not stay as they are forever.

COLOSIMO I don’t think significantly higher inflation is a massive risk. One thing that has not been discussed is just how much the nature of consumption has changed during the pandemic. We hear a lot about supply-side issues, but when one can’t really consume services there is a tendency to buy more things. We have seen a massive push to goods retailing and away from services.

This is inflationary, but once it begins to reverse – and we start to go on holidays and enjoy other services again – I think it will help ameliorate the supply-side issues we have seen. This should help moderate inflation.

YETSENGA I think this works to a point – but services are much more labour-heavy and many countries are already facing labour shortages. Services typically run at a higher average rate of inflation than the goods sector of the economy, so I think the opening trade is inflationary, not deflationary – and potentially quite sharply so.

The related issue is that, when we talk about higher inflation, we are talking about higher inflation within the tolerance band we have come to understand. I think to get meaningfully higher inflation, to say 5 per cent, will require institutional changes that will take years to bed down.

This would include a different regime of minimum-wage increases, a different way of businesses operating and a different way of the public sector treating its employees.

I don’t think any of these are really on the horizon, so we are talking about a rise in inflation within the tolerances we have come to understand.