Dr Brendan Rynne, KPMG Chief Economist, responds to RBA cash rate announcement – is the bond market right or is the RBA?

Even with the current surge in house prices, the RBA has not changed the cash rate today – no surprise, given it has been signalling rates could stay at historically low levels until 2024. But the real story of the past month is the extraordinary activity in the bond market. This leaves the question: is the bond market right or is the RBA?

Since the RBA Board met in early February, yields on 5-year and 10-year Commonwealth Government bonds have risen by 100 percent and 50 percent respectively, and the spread between the yields on Commonwealth Government and NSW Government 3 year bonds is now close to pre-pandemic levels. Clearly the market doesn’t think the RBA can hold the cash rate ‘lower for longer’.

Even without a formal adjustment in the cash rate these financial market movements would normally start to put pressure on domestic banks to start lifting their retail lending rates – but these are not normal times.

Since the acceleration of the pandemic in early 2020 there has been a switching in the funding composition of domestic banks away from more costly shorter term and longer term debt to firstly domestic deposits (as households looks to reduce their capital risk by moving from equities to cash) and secondly through banks taking up the ‘new’ funding made available from the RBA through quantitative easing (QE) – the Term Funding Facility (TFF).

Simply put, the additional firepower added to the macroeconomic policy response available to the RBA to combat the economic consequences of the coronavirus pandemic means the funding pressure on domestic banks from rising long term yields has been negated.

So while the long term bond yield is normally a reflection of the expected cash rate profile and a term premium, the RBA’s extraordinarily accommodative stance in setting the policy rate in these extraordinary times means this relationship is being massaged by the suite of policy tools being actively employed by Australia’s Central Bank.

Continuation of the current monetary policy approach suggests our cash rate will stay at 0.1 percent for the foreseeable future, despite what the markets are pricing in. The question is – whether the bond market is right, in which case the RBA will fall behind the curve and have to scramble to raise rates to validate the bond market, or whether the RBA is right and the bond market retreats.

The current surge in house prices is not abnormal given the circumstances. House prices growth will cycle up because interest rates are very low; the availability of funding is high (through QE expansion); stock levels are weak; and both savings and pent-up demand have built up during the COVID-induced lockdowns of 2020.

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