Michele Bullock’s anxiety is growing – with good reason

CBA issued $1.25 billion of a Tier 2 bond that paid a 205 basis point spread above BBSW. It also offered a fixed-rate version of this bond that paid roughly 6.5 per cent per annum. The demand for this security was an enormous $3.1 billion (we bid for $395 million).

As some of the more sophisticated superannuation funds have noted, liquid, investment-grade bank bonds paying 6.5 per cent in annual interest are extremely attractive relative to riskier alternatives, such as listed equities and illiquid venture capital, infrastructure, commercial real estate, junk bonds and private debt.

CBA is one of the smartest debt issuers globally and left a new issue concession for investors, which helped the bond subsequently perform. After the deal was priced, it was bid about 195 basis points above BBSW, providing a 0.4 per cent capital gain.

The Queensland government also came to the party this week, issuing $2 billion of an AA+ rated 2036 bond that offered a 5.25 per cent annual fixed interest rate (we bid for $150 million). These are very liquid securities that can be traded in $100 million-plus parcels.

The bond quickly performed with its interest rate spread above the Commonwealth bond yield curve contracting several basis points, delivering price appreciation on an interest rate hedged basis.

Finally, the Commonwealth issued $8 billion of its long-awaited, AAA-rated 2054 bond, which galvanised almost $30 billion of bids (we bid for $56 million). This paid 4.75 per cent in annual fixed interest and carried a small 2-3 basis point concession to its fair value curve, which was quickly priced out once the transaction was consummated.

Long-term government bond yields, also known as the risk-free discount rate, have been climbing as investors come to terms with the fact that the large interest rate cuts they thought they would benefit from this year and next have vaporised.

Central bankers are making it clear that they are waging a long, multi-year battle against inflation, where success is not remotely assured at current cash rate levels.

Shock after shock

Despite 400 basis points of interest rate increases from the Reserve Bank of Australia, the unemployment rate fell this week from 3.7 per cent to 3.6 per cent. This result will have surprised the RBA, given it was forecasting a gradual move higher in the unemployment rate to an average of 3.9 per cent over the final quarter of this year.

Goldman Sachs surmises that this might force Martin Place to lower its projections for the jobless rate by 0.2-0.3 percentage points.

Next week, we will get the third-quarter inflation data, which will be crucial in helping the RBA figure out whether it needs to nudge up its internationally modest 4.1 per cent cash rate to levels that are more in line with the 5-5.5 per cent range of global peers.

The new RBA governor, Michele Bullock, is clearly concerned that the central bank is forecasting that it will not reduce core inflation to 2.5 per cent until 2026, and has zero scope for upside surprises vis-à-vis further shocks to inflation.

During the week, she observed that “at the moment, inflation expectations for the very near term are elevated – they’re high”. “The challenge is to bring inflation back down in a reasonable period of time such that inflation expectations a year or so out don’t get de-anchored,” she continued.

“If inflation expectations continue to be elevated year after year and we don’t bring it back down, that will mean it will be harder to bring back down in the future. We have to be very alert to it – and we have to alert people to the fact that inflation continues to be higher than expected and if risks are on the upside, we’re going to have to respond with monetary policy. That’s what we’re going to have to make people understand.”

When asked if the war in the Middle East might force the RBA to sit on the sidelines for longer, Bullock said, “At the moment, we’re a little bit more concerned about the inflation implications of this”.

“Typically, you’d think supply shocks wash out, but we’ve had shock after shock after shock. The more that that keeps inflation elevated, even if these are all supply shocks, that impacts people’s thinking.”

The RBA has several idiosyncratic challenges to contend with. The first is that the savings buffers Aussie households built up during the pandemic, worth more than 20 per cent of their annual income, are much larger than those accumulated by consumers in peer countries.

This is because our fiscal policy was more profligate and households saved more because of tougher lockdowns.

But this cash is now being spent, which is contributing to excess demand and inflation. And whereas the excess savings buffers in the US are likely to run out in a few months, Australia’s buffers will last until late next year. This implies that the RBA may have more wood to chop than the US Federal Reserve.

Worst of all worlds

A second issue is that Aussie banks have acted very differently to the last three monetary policy tightening cycles. Normally, the banks pass on all the RBA’s rate increases and then some. In this cycle, intense competition for market share has meant that they have spared variable-rate borrowers more than two standard 25 basis point rate increases (or 68 basis points in total). Put differently, existing variable rate borrowers have experienced only 332 basis points of rate increases.

Recall our analysis showing that interest rate increases in Australia have no greater impact on inflation than the same moves in the US and Europe. Given it has lifted rates by less, the RBA is not yet displaying the same resolve to fight inflation as the Fed and the ECB.

A final wrinkle is that Australia is once again facing a very elevated terms-of-trade boom coupled with world-beating population growth, which can contribute to driving excess demand.

You get a sense of Bullock’s burgeoning anxiety when she says, “We think we’re running the narrow path but we’re very alert to the upside risks because we think that would be the worst of all worlds really”.

This year, anyone long equities or risky assets has cheered the upside economic surprises as evidence that we will avoid a recession and profit from the much-mooted soft landing. But if demand-side services inflation remains sticky, and “unit wage costs”, which are wages growth less productivity, continue to expand at a rate well above the RBA’s 2.5 per cent inflation target, the probability of the central bank having to force a sharper downturn, or even a recession, to tame inflation will only increase.

That is why Bullock says upside economic surprises, which might otherwise be welcome, could be the worst of all worlds.