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Bond Rout Forces Australia Policy Shift in Lesson for the World

Bond Tsunami Forces Australian Policy Switch in Lesson for World

Bond market one, central banks zero. 

That’s the headline score after a bruising week in global markets forced a policy change in Australia that’s sent ripples across the globe. But market moves in the wake of the decision suggest traders are unsure about just how far they can push the world’s central banks.

Spiraling inflation set the ball rolling for Australia, sparking a selloff in local debt markets that boosted yields more than eight times higher than the central banks’s target. Reserve Bank of Australia Governor Philip Lowe ditched his 0.1% cap on Tuesday, as central bankers worldwide struggle to convince traders and households that they won’t let inflation get out of control. 

The RBA’s climb down in the face of the biggest yield spikes since the 1990s shows how policy makers may struggle to stave off investor demands for action. The Federal Reserve, Bank of England and European Central Bank are among those confronting accelerating bets for tighter monetary policy as they battle to unwind unconventional settings while persuading markets that conventional tools -- benchmark borrowing costs -- will remain near the lower bound for as long as necessary. 

Bond Rout Forces Australia Policy Shift in Lesson for the World

In a statement accompanying the RBA’s decision to end its 20-month experiment with yield control, Lowe acknowledged he was effectively bowing to the market forces. 

“Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished,” Lowe said.

Global Waves 

The speed of change in the narrative is remarkable given the RBA just last month reiterated that conditions for a rate increase were unlikely to be met before 2024. 

Still, while Lowe conceded that there is now potential for higher rates in 2023, his insistence on remaining patient led Australian markets to pare back some of the most aggressive bets for early hikes, and spurred some global flattening trades to be wound back also.

Money markets pared bets on an ECB deposit rate hike to 13 basis points by the end of next year, compared with 20 basis points previously. Italian debt, which had led Europe’s recent bond declines, rallied to narrow its premium over German peers by eight basis points, the biggest tightening since February. Traders also shaved 10 basis points from their expectations for BOE tightening by the end of 2022. 

The Fed is expected on Wednesday to announce plans to roll back its stimulus, while the BOE meets Thursday.

When it comes to the central bank tool kit though, Australia’s scrapping of the yield target means the hurdle is much higher for another central bank to adopt the policy in the future. 

‘Important Lessons’

The RBA experience also shows that combining a bond yield target with outcome-based guidance isn’t ideal, because the policy becomes vulnerable to rapid shifts in expectations.  

“The RBA was a pioneer in front-end yield targeting, and the apparent demise of this experiment has important lessons for other central banks,” Krishna Guha, head of central bank strategy at Evercore ISI in Washington, wrote in a note to clients before the meeting.

Bond Rout Forces Australia Policy Shift in Lesson for the World

The central bank’s shift has come amid a faster-than-expected vaccination take up in recent weeks, which allowed Australia’s biggest cities to reopen from their rigid coronavirus lockdowns. Meantime, government support stopped unemployment from climbing to levels the RBA had feared, setting the scene for a robust recovery late this year and into 2022. 

At the same time, short-end yields have been spiking around the globe over the past month, with investors rushing for the exits after deciding that the acceleration in inflation is going to last. Any hint that central banks might still regard the surge in cost pressures as transitory simply fed the fire by igniting fears that policy makers were going to lose control of their economies.  

Benchmark yields at the short end -- those most sensitive to policy rates -- jumped by the most in years for key developed markets. Japan’s were held down as the BOJ maintained its curve control, while Australia’s were the extreme outlier with the biggest increase since 1994 as the RBA’s grip loosened. 

The following table shows the moves in key markets in October, using three-year bonds in Australia where that is the key short-dated security, and two-year notes for the others.

CountryMove in basis pointsBiggest Since
U.S. 22April 2018
Germany10October 2019
U.K.30November 2009
Canada56March 2002
Italy42August 2018
Australia* 91June 1994

The RBA’s ditching of yield control leaves the Bank of Japan alone among major central banks in still using the policy, after others including the Fed considered it and decided it wasn’t for them. The RBA’s abrupt end is perhaps the only way for a YCC exit, given any signal of such a change would see bond markets rapidly price in the departure.  

“For other central banks that watched the RBA experiment with interest, the takeaway is not encouraging,” Evercore’s Guha added. “Skeptics will see in the RBA experience proof that a yield target is like an FX peg and will always be vulnerable to breaking when the expected rate path shifts in a way that is not consistent with the stated target.”

©2021 Bloomberg L.P.