Bond traders searching for an opportunity to challenge central banks are starting to look Down Under, where a likely showdown over yield-curve control is set to test the power of policy makers to contain the next wave of reflation bets.
The global trading day for bonds begins in earnest in Sydney each morning, giving developments in Australia’s $600 billion sovereign debt market an out-sized impact on sentiment. It was the scene of a dramatic “flash crash” last year when the yield program was announced, illustrating the potential for turmoil.
While the Reserve Bank of Australia has largely tamed markets since then, as the economy’s recovery strengthens, wagers against the RBA’s ability to keep yields lower look poised to rise.
“If inflation expectations do start to un-anchor, then I think the RBA will be one of the first central banks to be tested by bond traders,” said Shaun Roache, an economist at S&P Global Ratings in Singapore. “The RBA is a canary in the coal mine for central banks as it is ahead in its labor market recovery.”
The RBA brought short-sellers quickly to heel when the global bond rout emboldened them to test its grip on yield control in February. After weeks of aggressive positioning by traders, the bank nudged up the cost of speculating on rising rates and the yield on benchmark three-year bonds fell neatly back into line with its 0.1% target.
But keeping the market at bay next time may prove more difficult, as vaccination campaigns gather pace in major economies and the U.S. recovery nears an “inflection point,” emboldening traders. Pressure is already apparent in Australia’s three-year swap rate, which is increasing the costs of managing interest-rate risks for corporate borrowers.
If yield control fails in Australia, it may fade away as a potential option for other monetary authorities in need of more policy ammunition. Especially because yield control’s record in Japan—the only other country to officially employ it—is patchy.
Pinning the rate of one key bond maturity has helped the Bank of Japan reduce borrowing costs in general and also allowed it to slow the pace of bond purchases. But it has come at a cost. The nation’s debt market is lambasted as dysfunctional and an economic recovery strong enough to revive inflation looks as far away as ever.
Widening Gap
Beneath the surface, problems are building Down Under too. While the RBA has its thumb on one specific bond line, there is a large gulf between the yield on this security and those maturing slightly later. There’s also a widening gap to rates on the suite of derivatives linked to three-year yields that flow through into borrowing costs for companies and consumers.
The three-year swap rate surged through February and March, rising to four times the RBA’s target for three-year bonds amid pressure from higher U.S. yields and a rebounding economy at home.
Australia’s bond futures tell a similar story. The yield implied by three-year futures doubled in the two weeks to Feb. 26 and remains elevated, even after retreating from its high point.
“Lack of liquidity, a central bank that’s digging its heels in—all that, for us, means there’s going to be more volatility in Aussie rates,” said Kellie Wood, a fixed-income portfolio manager at Schroders Plc’s Australian unit. “The RBA has succeeded in terms of round one. But we are starting to see cracks,” said Wood, who expects the market to challenge the 0.1% target again.
Stephen Miller, an investment consultant at GSFM, an arm of Canada’s CI Financial Corp., agrees that higher yields may arrive in Australia sooner than the RBA thinks. “It will be powerless if the U.S. curve shifts upwards and other rates markets follow,” said Miller.