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Debt cost spike presents a few challenges for RBA

John KehoeSenior writer

Government interest costs are on track to blow out by $15 billion over the next two years because of a sudden jump in bond yields, putting pressure on the Reserve Bank of Australia to consider more aggressive interventions in bond markets to suppress borrowing costs.

Rising economic optimism – stoked by the vaccine rollouts, easing health restrictions, high commodity prices and a planned $US1.9 trillion ($2.47 trillion) stimulus by US President Joe Biden – has fuelled a jump in borrowing costs around the world, particularly in Australia and New Zealand.

Investors are betting big against Philip Lowe’s expectation that the cash rate will remain anchored at 0.1 per cent until at least 2024.  Alex Ellinghausen

In an attempt to contain surging bond yields and the strong Australian dollar, the RBA stepped in with more than $7 billion of federal and state government bond purchases in the secondary market last week.

But investors bet against RBA governor Philip Lowe’s expectation that the cash rate would remain anchored at 0.1 per cent until at least 2024.

The sharp sell-off in Australian government debt temporarily pushed up the yield on the 10-year bond to above 1.9 per cent last week.

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If sustained, the government’s borrowing cost would be double the 0.9 per cent assumed in the federal budget in the short term, according to Kieran Davies, a former Treasury forecaster and now chief macro strategist at Coolabah Capital Investments.

“As a ballpark estimate, higher yields might add up to $2 billion to $3 billion [interest costs] to the budget for this financial year given there are only four months left in 2020-21, but with more effect next financial year assuming the increase in yields is sustained,” Mr Davies said.

It is important to emphasise that the RBA has not lost the bond market or the currency market for that matter.

— Grant Wilson, hedge fund adviser

More positively for the budget, he said, the stronger economic recovery, lower welfare payments and high iron ore price have delivered a $14.5 billion budget windfall, shrinking the deficit to $133 billion in the first seven months of the financial year to January 31.

That fiscal improvement was largely before the spike in bond yields in recent weeks.

If the 10-year bond rate remains elevated near 1.9 per cent, federal debt servicing costs would jump by about $10 billion next financial year.

The state and territory government debt pile of about $500 billion would also face higher interest repayments running into multibillions of dollars.

The RBA board will consider higher government bond yields at its monthly policy meeting on Tuesday, as the market challenges its easy-money plans.

ANZ economist Felicity Emmett said the RBA’s statement on Tuesday was likely to emphasise that the bank had the option to increase its $200 billion government bond-buying program and express angst about the Australian dollar after it briefly broke above US80¢ last week.

“The RBA will likely be back into the market again in size on Monday unless yields drop,” Ms Emmett said.

‘A rough week for bond markets’

However, hedge fund adviser Grant Wilson said that while it had been a “rough week for bond markets”, the RBA should hold its nerve against investor demands for more bond purchases and continue to monitor the economic recovery.

“It is important to emphasise that the RBA has not lost the bond market or the currency market for that matter,” Mr Wilson writes in The Australian Financial Review.

“The bond market is quite capable of discovering its own prices in the meantime.”

Global bond yields retreated and the Australian dollar fell to US77¢ at the weekend following trading in New York and London, easing fears about the vicious bond market sell-off earlier in the week.

Market sources attributed the sharp reversal to global hedge funds and other institutional investors closing out bond positions and unwinding currency carry trades at the end of February for reporting their monthly performance.

Before the recent jump in bond rates, federal government interest debt costs in December were forecast to be $20.6 billion in 2020-21 and $19.8 billion in 2021-22 – very low by historic standards despite gross debt being on pace to exceed $1 trillion.

RBA governor Philip Lowe has dismissed claims the bank is helping fund the government, but he has admitted that one of the benefits of quantitative easing is to lower government borrowing costs to encourage stimulus spending, including by state governments.

Central bank on alert

The RBA is certain to be on alert to any renewed bond market turmoil and upward pressure on the Australian dollar over the coming days.

The central bank has struggled to pin the three-year yield at its 0.1 per cent target. It has traded as high as 0.14 per cent in recent days, although the yield eased back to 0.11 per cent at the weekend.

Billionaire investor Warren Buffett, chief executive at Berkshire Hathaway, told investors in his annual letter at the weekend that “bonds are not the place to be these days”, because of the relatively low yields.

At an online meeting of Group of 20 finance ministers and central bank governors at the weekend, US Treasury Secretary Janet Yellen urged members to continue to inject “significant fiscal and financial policy actions and avoid withdrawing support too early”.

“If there was ever a time to go big, this is the moment,” she said.

New York-based TPW Advisory founder Jay Pelosky said the world was experiencing its “first bond bear market in 40 years” because investors had been “spooked” by the huge Biden fiscal stimulus that passed the US House of Representatives at the weekend and which now required approval by the US Senate.

Finance Minister Simon Birmingham said in February that the December budget update assumed interest rates would converge towards their long-run level over a 15-year period.

Gross debt burden

But if rates return faster to more normal levels over 10 years, the increase in interest payments would add a further $44.5 billion to gross debt in a decade’s time, he said.

“We cannot assume that such low interest rates will always be there,” Mr Birmingham said.

Oxford Economics economist Lydia Boussour said global investors had suddenly repriced economic growth and inflation expectations, amid a broad rally in commodity prices.

Fitch Ratings revised its metals and mining price forecasts higher for nickel, copper, zinc, aluminium, gold and coal. Australian iron ore export prices were upgraded by 67 per cent to $US125 a tonne for this year, well above the federal budget forecast of a gradual decline to $US55 a tonne.

Meanwhile, household financial comfort has hit a record high, according to ME Bank’s latest Household Financial Comfort Report.

“While the majority of households reported increased financial comfort, a subset recorded declines, most notably, the unemployed, students and casual employees – most likely a result of government support beginning to be withdrawn and a weak labour market,” said Jeff Oughton, a consulting economist at ME Bank.

“The pandemic has triggered many households to proactively reorganise their finances, helping to bolster their financial resilience through the pandemic and the uneven economic recovery under way.

“Households have increased cash savings, cut overspending, paid down debts and withdrawn retirement savings to improve their ability to handle the emergency. This precautionary behaviour supported by the sizeable temporary government income support and very accommodative banking and financial conditions has no doubt helped drive financial comfort to a new record high in December.

“However, paradoxically, if Australians stay precautionary in their spending and maintain their big saving buffers, an inclusive and durable recovery may be jeopardised, which will unfortunately hurt many of those same households with low levels of comfort the most,” Mr Oughton said.

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Summary | 2 Annotations
significant fiscal and financial policy actions and avoid withdrawing support too early
2021/02/28 20:55
US Senate.
2021/02/28 20:56