How the RBA’s attempt to control yields impacted the bond market


A move that was taken to ensure Australia stays afloat during the pandemic is now wreaking havoc on the economy.

Throughout history, mankind’s attempts to tame things and bring them under our control have been a constant engine of technological and social development.

From the first domestication of canines to harnessing millions of tons of rocket fuel to send us into space, we’ve already reached that next horizon, even if at times it has literally exploded in our face.

But after millennia of achievement, there is still something that often finds a way to trip us up, the unpredictable realities of human nature.

This brings us to recent failed attempts by the Reserve Bank to control something that could be indomitable, the trillion dollar Australian government bond market.

The bond market

Through the bond market, the federal government, states, and businesses borrow money from investors in order to finance projects or simply pay their bills.

The interest rate or return on debt is determined by the rate at which the market (investors) is willing to lend, based on the risk of the investment, the expected rate of inflation and a number of other factors.

By design, bonds are meant to be a liquid asset, as they can be bought or sold relatively easily in a well-established and regulated market.

Due to this ease of transactions, they are often traded and the price can fluctuate significantly even in the course of a single day.

While the interest rate payable by the issuer of the bond, for example the federal government, remains the same throughout the life of the bond, the interest rate to be received by a potential buyer of bonds may vary depending on the price at which he bought it.

Just as the yield on an investment property changes when a new owner buys it at a higher price when the rent stays the same, the yield on a bond also changes with its price when it is priced. changes hands.

RBA tries to fix the game

At the height of the turmoil in financial markets in March last year, the RBA announced it would introduce yield curve control.

Clearly, the RBA has committed to buying a specific government bond due for redemption in April 2024, to ensure that the bond yield never significantly exceeds 0.25% per annum.

In doing so, the RBA attempted to ensure that the federal and state short-term borrowing costs would be pinned at this 0.25% rate for the life of this bond, giving them substantial leeway to borrow. money to finance stimulus packages in the event of a pandemic. .

But the government was not the sole beneficiary of the RBA’s attempts to fix the game.

By committing to keeping the costs of financing the bond market low, they have also enabled banks to finance mortgages at these low rates for years to come.

In November 2020, the RBA lowered its target to just 0.1%, ensuring that short-term borrowing costs would stay at or below that level until April 2024.

But it didn’t have to be.

Beach balls and the uncontrollable

For nearly 18 months, the RBA’s attempts to control borrowing costs were largely successful, amid broader economic uncertainty.

But as worries about inflation continued to mount, all of a sudden it became much more difficult to control borrowing costs and quickly became completely unworkable.

In trying to suppress rising borrowing costs, the RBA was effectively holding a beach ball underwater as it tried to keep the market in check.

Despite the RBA’s previous attempts to hold on, borrowing costs through April 2024 made what beach balls do when you hold them underwater, explode higher.

On October 25, the RBA’s target bond was yielding 0.125%, a reasonable distance from the central banks’ 0.1% target.

Just four days later, it peaked at 0.775%, nearly eight times the RBA target, amid growing concerns about inflation and rising global yields.

With this explosion in the relative cost of borrowing, the RBA’s attempts to rigidly control elements of the bond market effectively came to an end, with the RBA finally officially waving the white flag on Tuesday.

The sequel and the consequences

While markets and economists will always sit down and notice when the RBA issues a statement or the governor holds a press conference, one would imagine their forecasts are now being taken with more than a pinch of salt, after their spectacular (by bond market standards) beach ball moment.

Since rates exploded, markets have calmed down. As of Wednesday’s close, money markets were counting on three rate hikes by the end of next year, instead of the four expected at the end of last week.

The RBA has now changed its mind about excluding rate hikes before 2024, now taking a more data-dependent approach rather than the broad statements that have defined their recent rhetoric.

As the market anticipates an aggressive rate hike cycle, it remains to be seen when rates will actually rise. Economists are widely divided on the matter, with some suggesting it could happen next year, while others believe it could be towards the end of 2023 before the RBA finally pulls the trigger.

Ultimately, as this attempt to control what can be out of control has shown, no one knows the future, not even one of the most resource-rich organizations on the planet, especially now.

Tarric Brooker is a freelance journalist and social commentator | @AvidCommenter

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