The bonds would be sold either to investors on the open market or directly to the government’s debt management agency, the Australian Office of Financial Management (AOFM), which is part of the Treasury portfolio.
Any move to sell the bonds would be aimed at reducing interest-rate risk on the RBA’s $610 billion balance sheet and stemming potential further losses.
As interest rates (yields) rise on bonds, the capital value of bonds fall.
But any bond sales would be gradual and not aim to use QT as an active monetary policy tool to push bond yields higher or tighten financial conditions.
RBA governor Philip Lowe has said the overnight cash rate, currently 4.1 per cent and priced by money market traders to go higher, remains the bank’s primary tool now that interest rates are no longer anchored near zero.
A decision on QT will be made after September 30, to assess the market impact of commercial banks repaying almost half – $84 billion – of the money borrowed from the RBA’s emergency term funding facility (TFF).
The TFF loaned banks $188 billion at three-year fixed rates as low as 0.1 per cent to provide cheap loans to households and business. It was closely intertwined with the RBA’s purchase of $330 billion federal and state government bonds.
The RBA originally insisted it would hold the bonds, with tenures between three years and 10 years, to maturity to avoid realising capital losses.
But RBA May board meeting minutes revealed that members began reviewing the bank’s approach to reducing its holdings of government bonds, which had been purchased from 2020 to 2022.
Treasury secretary and RBA board member Steven Kennedy told an Australian Business Economists’ event last month that the run-off of the RBA balance sheet would have potential implications for the AOFM’s debt management for the federal budget.
“If the board was to change its view from passive unwinding, its current position, it will go on to speak to government,” Kennedy said.
“What was recorded in the [RBA] minutes was where we think it’s sensible given the change in the balance sheet to consider this issue over time.”
“Other central banks are taking slightly different approaches, but most are using passive.”
Many central banks have been passively allowing bonds to roll off their balance sheets as they mature, but central banks in New Zealand and England are actively selling their bonds with little market disruption.
An argument against selling the bonds is potentially inciting bond market dislocations, particularly if the RBA suddenly sold a large chunk of the government debt on the open market when the AOFM was issuing new debt in the same part of the yield curve.
Hence, the RBA intends to co-ordinate with Treasury, the AOFM, and, possibly, state debt agencies whose debt it also holds.
The federal government budget’s shift to surplus and lower forecast deficits in future years may provide an opportune time for the AOFM to soak up the RBA’s bonds in an orderly fashion.
The AOFM plans to sell about $75 billion of Treasury bonds next financial year – largely to replace maturing existing bonds – in what would be its lowest debt issuance since 2018-19 when the budget was in balance.
Either way, the AOFM would need to borrow money to replace the RBA-held bonds – when they mature as scheduled in the years ahead or earlier if the RBA sells them directly to the government.
The AOFM would have the option to re-sell the bonds at a time of its choosing, making the overall impact on the government’s balance sheet broadly neutral over time.
One advantage of using the AOFM as an intermediary is that the government’s debt agency is more experienced at selling government bonds to market participants such as investment banks, pension funds, insurers and sovereign wealth funds.
The AOFM may be able to achieve better pricing and cause less market disruption.
The scenario is complicated because Lowe has wanted to avoid perceptions that the independent central bank was working too closely with the government to finance taxpayer spending during the pandemic.
Hence, the RBA bought government bonds on the secondary market and not directly from the government, but the overall effect was lower government borrowing costs.
Nevertheless, the RBA maintained close dialogue with the AOFM and state debt agencies about its bond buying and their debt issuances during the pandemic, to ensure their actions didn’t clash.
For example, some state treasury arms asked the RBA not to buy bonds beyond 10 years – as the Bank of England did – because there weren’t many very long-dated local bonds available in Australia and it would risk scaring off long-term market investors.
AOFM chief executive Anna Hughes said on Thursday she was aware of “market chatter” about the RBA’s bond holdings.
Anna Hughes, Australian Office of Financial Management CEO, says any changes of course would be clearly and transparently communicated. Alex Ellinghausen
“While there has been considerable speculation around this, I would point out that the RBA’s position on its bond holdings is the same today as it was prior to the release of the May board minutes. That being said, that they have no current plans to sell and that their portfolio will simply run down passively with maturities.
“Should this position ever change, you can expect that we will work co-operatively with the RBA in the best interest of the AGB [Australian government bond] market.
“It would be in no one’s interest, least of all our own, if the RBA and AOFM were selling bonds into market in an unco-ordinated manner.
“Given our shared interest in a functional and liquid market, I am confident that if the hypothetical were to become a reality, that it will be clearly and transparently communicated, and that any disruption will be avoided.”
The RBA originally began buying about $40 billion of government bonds in March 2020 to stabilise financial markets when pandemic lockdowns hit, by targeting a yield on the three-year bond of 0.25 per cent, and later 0.1 per cent. This backed up Lowe’s guidance that interest rates were unlikely to rise until 2024.
In November 2020, the RBA followed foreign central banks by launching a much bigger $281 billion QE stimulus by buying federal and state bonds with maturities of between three and 10 years.
The total size of its yield curve target and bond purchases was about $330 billion until February 2022 after lockdowns ended following the omicron COVID-19 wave.
The main objective was to push down yields, prevent the Australian dollar appreciating as other central banks eased policy and to encourage governments – particularly states worried about their credit ratings – to take advantage of the lower interest rates to borrow to fund stimulus such as infrastructure projects.
The RBA estimates it lowered yields by about 0.3 of a percentage point, helped put downward pressure on the Australian dollar and supported cheaper borrowing by governments, business and households.
RBA deputy governor Michele Bullock said in September that QE and the TFF contributed to a stronger economy, lower unemployment and a better government budgets due to cheaper borrowing costs.
The paper losses on its revalued bond portfolio will show up as a gain on the balance sheet of the government’s debt issuer, the AOFM, and be neutral on the combined public sector sheet, she said.
But some outside observers including the independent review of the RBA, market participants and former Treasury economist Peter Downes have criticised the bond-buying program in Australia.
The yield curve control target came to an undignified end in November 2021 when it became obvious financial markets no longer respected it and bet heavily against the RBA’s 2024 interest rate rise guidance. The sloppy exit caused chaos in bond markets and hurt the central bank’s reputation.
Moreover, the RBA review suggested board members were not made properly aware of the balance sheet risks the bank was exposed to from the intersecting QE and TFF policies that have since led to multibillion-dollar losses.
Downes argues that the marginal downward pressure on the exchange rate did not outweigh the balance sheet risks.
Any weaker currency benefits to boost exports were muted by the closure of the international border stopping foreign tourists and students from entering, and physical exports being limited by pandemic supply chain disruptions.
Moreover, Australia’s predominantly variable home loan interest rates do not price off longer-term bonds that the RBA was buying, limiting the flow through to mortgage holders.
While the TFF pushed down fixed mortgages to about 2 per cent for home borrowers, Australian variable-rate home loans price off three-month and six-month bank bill swap rate and not long-term bond yields.
In contrast, the United States lending market for 30-year fixed-rate mortgages and corporate loans is more influenced by the US Federal Reserve’s bond-buying, so QE arguably flows through to the US economy and financial markets more.
A prescient warning
Moreover, Lowe warned in 2019 before the pandemic that there was “no free lunch” from the RBA financing the government, as he pushed back against so-called modern monetary theory.
“The tab always has to be paid and it is paid out of taxes and government revenues in one form or another,” Lowe said.
That warning has proven prescient.
But the onset of pandemic restrictions and the sharp economic downturn in mid-2020 convinced the RBA to buy government bonds from private investors, though not directly from the government as MMT advocates suggested.
Some three years after the RBA began buying bonds, too much stimulus from governments and central banks around the world pushed up inflation well above targets. The war in Ukraine also escalated global energy prices.
Central banks have been scrambling to tighten policy by ratcheting up their short-term cash rates.
A consideration for the RBA board is whether it is willing to suffer even bigger losses if the cash rate rises further.
When the RBA bought bonds from banks on the open market, the RBA credited the commercial bank deposit accounts held at the central bank, known as exchange settlement (ES) balances.
Banks also parked their excess TFF funding in the ES accounts and now have about $400 billion deposited at the RBA.
The dilemma for the RBA is that it is running a loss-making trade, by paying the banks higher interest rates on ES balances than the yield the central bank is earning on the bonds it bought.
The RBA bought bonds with 10-year yields as low as 1.5 per cent to 2 per cent and is now paying out 4 per cent on $400 billion of ES balance.
As the cash rate rises and the interest rate the RBA pays commercial banks on their ES balances increases, the RBA is also making ever larger losses to commercial banks on the spread between TFF loans and ES balances.
The RBA loaned the banks $188 billion of three-year fixed rate money for between 0.10 and 0.25 per cent, but is now paying the same banks 4 per cent on their large ES balances at the RBA.
The RBA has already marked-to-market the paper losses on the value of the bonds, but selling them before maturity would crystallise the losses. It reported negative equity of $12.4 billion last financial year after reporting an accounting loss of $36.7 billion.
Economists such as former RBA board member Warwick McKibbin and Peter Downes have called for the government to recapitalise the RBA through an equity injection of more than $10 billion. But the RBA and Treasury insist the bank can gradually rebuild its balance sheet out of negative equity over the years ahead, without affecting its ability to operate monetary policy.
Selling the bonds could save the RBA board from further embarrassing losses reported in its annual reports if interest rates were to rise further.
Conversely, if the bonds were sold and interest rates fell over the next few years before the bonds mature, the RBA could forgo potential future gains.
Banks have begun slowly repaying the TFF and are due to return $84 billion of the $188 billion to the RBA by September 30. The remaining balance is due by June 2024.
The RBA has said it will closely monitor how smooth or volatile this is.
Regional banks with relatively small ES balances need to raise money from wholesale markets or depositors to repay the TFF money.
The big four banks have huge ES balances at the RBA, accounting for most of the $400 billion deposited at the central bank. They could draw on this money to repay the RBA.
However, the cash in the ES balances – including TFF money with maturities longer than 30 days – qualifies as high-quality liquid assets to meet the Australian Prudential Regulation Authority’s liquidity rules.
Hence, in practice, the big banks need to raise money from depositors or borrow money on wholesale markets to buy federal and state government bonds to meet APRA’s liquidity ratios.
“Consequently, as the banking sector runs down its ES balances to repay the TFF, it will need to obtain other HQLA in order to maintain liquid asset ratios, which are currently well above regulatory requirements,” the RBA’s Statement on Monetary Policy noted in May.As money is drained from the ES accounts, the RBA wants to observe if there is any impact on financial sector stability, before deciding on its bond holdings.
RBA more circumspect
More broadly, looking ahead after Australia’s QE experience during the pandemic, some central bankers and market participants now believe that QE is most useful to inject liquidity during market dysfunction.
Prime examples are when liquidity evaporated from local money markets during the March 2020 initial COVID-19 lockdown shock and when the Bank of England stepped in last year amid an investor revolt over £45 billion of unfunded UK tax cuts.
Central banks can take a long-term view, ride out turbulence and potentially reduce their balance sheets when the turbulence subsides, as the Bank of England did.
Beyond market disruptions, the surge in inflation and fiscal losses from bond buying is likely to make the RBA more circumspect about buying bonds to stimulate the economy in the future.
Instead, Australia’s federal government has relatively low debt by international standards and fiscal capacity to provide stimulus during a future recession.
Market participants are split over whether the RBA will move from a passive reduction of its balance sheet or do active QT by selling bonds.
UBS analysts think the RBA could easily sell $1 billion a week of bonds between late 2023 and early 2027, similar to the RBNZ roll-off profile.
Commonwealth Bank of Australia strategists believe QT is unlikely this year.
RBA board meeting minutes from May and public comments from officials suggest the RBA remains open-minded about whether it will move to active QT or keep allowing the bonds to roll off its balance sheet passively.
“As had been decided by the board a year earlier, the strategy was to hold these bonds until maturity rather than selling them prior to that,” the minutes said.
“This approach recognised that the bank’s balance sheet was already set to decline rapidly given the maturity of funding under the Term Funding Facility, and that bond sales might complicate governments’ bond issuance and reduce the effectiveness of any future quantitative easing (QE) program.
“Members agreed that this approach remained appropriate for the time being.
“However, they noted that the initial tranche of Term Funding Facility maturities would occur in coming months and would provide information on how financial markets respond as the Bank’s balance sheet declines.
“More generally, the bank’s large holdings of government bonds exposed its balance sheet to a significant level of interest rate risk.
“Accordingly, members agreed it was appropriate to review the current approach periodically.”