Quantitative tightening

Delivered on By Justin Pyvis

Good morning! Albo was hurriedly sworn in as PM yesterday, along with four key ministers, ahead of a trip to Tokyo where they will meet with the ‘Quad’, which includes leaders from the United States, India and Japan.

It’s unlikely that anything substantial will emerge from the meeting other than the already-revealed Indo-Pacific Economic Framework – Albo’s due back in Australia tomorrow, after all – but it will be important to set the tone for the next three years, especially considering that the last Labor government famously walked away from the previous Quad iteration amid speculation that Australia “was ‘tilting’ in favour of China”.


Reading the tea leaves

Daily % change

AUD/USD

71.1

+0.7%

AUD/CNY

4.72

0.0%

AU Bond

3.34

+3.0%

US Bond

2.86

+2.6%

ASX200

7,149

+0.0%

S&P500

3,974

+1.9%

Brent (bbl)

113.5

+0.8%

Gold (oz)

1,852

+0.6%

Iron ore (t)

134.0

-0.1%

Bitcoin

29,341

-3.2%

Ethereum

1,997

-2.3%

Note: Brent oil, gold bullion and iron ore prices are the second futures contract. Bond yields are 10-year Treasuries.

The US S&P500 gained +1.86% overnight after US President Joe Biden said he was considering cutting tariffs on Chinese goods and JPMorgan’s CEO Jamie Dimon talked up the US economy at the firm’s investor day:

“Strong economy, big storm clouds. I’m calling it storm clouds because they’re storm clouds. They may dissipate. If it was a hurricane, I would tell you that.”

Locally, the ASX200 edged up 0.05% thanks largely to the materials sector (+0.8%) following the rise in iron ore prices on Friday.


Food for thought

The RBA has a lot of government debt to offload over the next decade.
The RBA has a lot of government debt to offload over the next decade. Source

Rising inflation, structural budget deficits and slowing economic growth won’t be the only issues Albo will have to tackle in the coming months. He’ll also have to contend with so-called “quantitative tightening” (QT), a process where the Reserve Bank of Australia (RBA) shrinks its balance sheet. According to Christopher Kent, one of the RBA’s Assistant Governor who gave a speech on the subject yesterday:

“By allowing our bond holdings to gradually diminish over time as they mature, the initial stimulatory effects of those holdings – namely, downward pressure on government bond yields and the Australian dollar exchange rate – will gradually unwind.”

During the period of “quantitative easing” (QE) between November 2020 and February 2022, the RBA printed a bunch of Aussie dollars (electronically) and purchased government bonds, totalling around 35% of Australia’s debt on issue (see chart above), “which was above the equivalent share for the US Fed, but still below other central banks like the Reserve Bank of New Zealand and the Bank of Canada”.

Now that QT is underway the RBA will start to realise losses on its holdings, because its bonds were all purchased on the secondary market at a time when yields were at record-lows (so it had to pay a premium). Unlike other central banks, the RBA didn’t seek a government indemnification against losses (incompetence?), meaning there’s a chance the RBA will soon become technically insolvent, especially after 2024:

“The decline in our bond holdings will be gradual over this year and next. The first major maturities from the Bank’s portfolio will be about $2 billion worth of the July 2022 Australian Government bond, followed by $2 billion of the November 2022 bond. The maturity of the April 2023 bond is much larger, at slightly over $13 billion. Maturities will then step up again to be more sizeable from 2024.”

Given the current rate of inflation, the RBA should at least be considering following other central banks that “have decided to sell bonds in order to run down their portfolio faster than otherwise”.

But the RBA is effectively handcuffed – if it started flogging bonds to accelerate the QT process it would incur losses in the tens of billions of dollars this year, forcing it to go cap in hand to the new Labor government asking for a large recapitalisation, adding to the nation’s record high debt.

While Kent conveniently omitted that fact in the RBA’s official narrative, which included gems such as wanting to avoid “adding to volatility in bond markets”, it’s probably closer to the truth than anything he said. We predicted as much last month [emphasis added]:

“[Q]uantitative tightening – the opposite of QE, where asset and consumer price growth is slowed by selling bonds to raise longer-term yields – will be virtually impossible in Australia without the RBA realising significant losses, potentially creating a bias towards easier monetary policy.”

Australia will get QT, just at a much slower rate than in other counties due to the RBA’s self-inflicted easing bias, meaning inflation will be higher, and bond yields and the Aussie dollar lower, than they would be had the RBA not painted itself into a corner.


Chewing the fat


Bits and bytes

🤝 Albo confirmed he struck a deal with “key crossbench members” (independents) before jetting off to Japan to ensure confidence and supply to his government in the event Labor fails to achieve a majority.

💩 Yikes: WA Premier Mark McGowan said the frontrunner to lead the Liberal party, Peter Dutton, is “an extremist, I don’t think he fits with modern Australia at all… I actually don’t think he’s that smart.”

⚔️ US President Joe Biden said the US would be willing to intervene militarily if China were to invade Taiwan, effectively ending the policy of “strategic ambiguity”.

📝 US President Joe Biden unveiled the Indo-Pacific Economic Framework, an agreement between the US and 12 Asian nations (including Australia but not China) for “negotiations for areas in four economic ‘pillars’: Fair and resilient trade, supply chain resiliency, clean energy and anti-corruption.”

🤒 Beijing reported a record number of COVID-19 cases yesterday, “reviving concerns the Chinese capital may face a lockdown”.

📈 Core inflation in Singapore, which excludes accommodation and private transport costs, increased 3.3% in April from a year earlier, the fastest rate of increase in over a decade.

🔌 The International Energy Agency reported that while electric vehicle sales remained strong in 2022 to date, “future growth will demand greater efforts to diversify battery manufacturing and critical mineral supplies to reduce the risks of bottlenecks and price rises”.

🏨 “Belgium has become the first country to introduce a compulsory 21-day quarantine for monkeypox patients after reporting four cases of the disease in the last week.”

🐒 A useful Twitter thread on monkeypox and “the unfolding scientific data on what we (don’t) know so far”.