Bond vigilantes and the end of RBA exceptionalism
Plus, Japanese inflation vindicates BoJ’s Kuroda, for now at least
Johnny Shapiro had a story on the widening in Australia-US yields spreads, quoting some market participants as saying that Australia’s underperformance was due to the RBA losing credibility following the collapse of its yield curve target last year and the change in its forward guidance on the cash rate target. Supposedly, some funds are shunning Australian bonds as a consequence.
Previously, I suggested that the demise of the YCT and retreat from the former forward guidance with respect to the cash rate was a symptom of monetary policy success rather than its failure. That is not to say that the RBA does not have a genuine inflation problem on its hands, but as I argued against the inflationistas back in 2020, that is not the worst problem to have given where we were until very recently. This time last year, I was packing my then office at the University of Sydney into the back of the car for what would turn out to be a 13-week lock-down.
In fact, the spread widening represents a renormalisation of Australian monetary policy and inflation outcomes after a period of Australian exceptionalism, but not of the good kind. Under Governors Macfarlane and Stevens, the spread averaged around 114 basis points, although with a fair bit of cyclical variation. The spread is loosely and positively correlated with the Australia-US NGDP growth differential, which makes sense give that NGDP growth is a rough valuation benchmark for 10-year bonds. While I would not trade off it given the backward-looking nature of NGDP growth data, it still has a role in a fair value model of the yield differential. This is yet another potential application of NGDP futures markets, at least for market participants.
Under Governor Lowe, however, the spread has averaged around parity and was consistently negative for the two years immediately prior to the pandemic. The spread was symptomatic of Lowe’s leaning against the wind strategy, which broke the domestic inflation process, giving rise to the Lowe residual and costing 270,000 jobs.
Bond market vigilantes are meant to punish governments for fiscal excess via higher interest rates, but fiscal policy has very little explanatory power for bond yields relative to monetary policy. Of course, we can think of bond vigilantes as punishing monetary excesses as well, but bond vigilantism is also symmetrical. Lowe’s policy of leaning against the wind was the perfect opportunity to buy Australian bonds and sell their US counterparts.
While I claim credit for having predicted yield parity as early as 2015, before Lowe even became Governor, I did not predict the extent to which Australian bonds would blow through parity and continue to outperform under Lowe’s LAW.
The claim that offshore bond market participants are shunning the Australian bond market is not immediately obvious from the data, at least for Q1. Admittedly, foreign portfolio investors were sellers of Australian government debt securities in the last two quarters of 2021, but were buyers again in the first quarter, using ABS data, which does not abstract from valuation effects.
Source: ABS
AOFM data lets us strip-out valuation effects and adjust for net repo flows and shows the strongest non-resident inflows into AGS in Q1 in absolute terms since Q3 2020, when earlier pandemic repatriation flows were being more than reversed. This was all attributable to longer duration AGS. The non-resident share of shorter-term AGS fell by more than one-half. Given the way the monetary policy outlook evolved over the quarter, that is not surprising. Call it vigilantism if you will. But this is all consistent with the renormalisation of Australian monetary policy and inflation after a period of RBA exceptionalism which still has its echo in Australia’s still somewhat lagging inflation performance.
This raises the question as to what the equilibrium Australia-US yield differential should look like. It is actually hard to make a structural as opposed to a cyclical macro case for a significant premium for Australian government bonds over US Treasuries. Australia’s fiscal position is stronger and its net international liability position has largely converged on that of the US, even before Australia became a net exporter of capital. There are exchange rate and liquidity risks of course, and monetary policy errors can drive big changes in the differential as we have seen under Governor Lowe. But the long-term trend narrowing in the differential has solid structural macro foundations.
Japan’s May inflation print vindicates Kuroda’s yield target
Japan released its May inflation data, which was steady on the headline and core measures. On the core measures, Japanese inflation is still below target and barely positive (chart due to Goldies):
The data vindicates Kuroda’s position that Japan’s headline inflation rate reflects supply shocks that the BoJ should look through.
Even so, the FT reports offshore investors doubling-down on the short JGBs widowmaker. The story notes the sharp disconnect between offshore and onshore perceptions of the continued viability of the BoJ’s YCT. While the prospective exit from YCT is necessarily messy and therefore a volatility event worth betting on in-principle, it is not inconceivable that the BoJ’s yield target will outlive the cyclical upswing in global bonds yields. Nominal bond yields and inflation break-evens have moderated globally along with commodity prices, while the June flash PMIs continued their roll over this week:
The recession talk is being priced in. The BoJ may well find itself successfully smoothing it way through this cycle, adding to the windowmaker’s multi-decade body count.
Another US inflation decomp
Since we linked to David Beckworth’s US inflation decomposition based on his NGDP gap, the equilibrium inflation rate and a residual attributable to supply shocks, we should also mention the latest update to the San Francisco FRB’s inflation decomposition. Their sign-based identification of supply and demand shocks is entirely consistent with the rationale for NGDP targeting. This approach suggests that more than half of the recent US PCE inflation rate is attributable to supply shocks:
This still leaves a need for monetary policy to address excess demand pressures, but also raises the risk of perverse monetary policy responses to supply shocks. While there is no unimpeachable way of decomposing inflation pressures into demand and supply shocks, trends in NGDP are still the best overall guide.
If you think inflation is mostly a supply-driven phenomenon, then you might want to join Governor Kuroda in going long bonds at this point.