Global hedge funds, sovereign wealth funds, pension funds and life insurers had bet that the RBA would keep its pledge to fix the April 2024 bond yield at 0.1%, or at least limit their losses if the policy was changed.
But higher than expected inflation arrived and bond yields soared, forcing the RBA to drop the peg. Shocked investors found the central bank no longer had their backs.
Suffering multibillion-dollar losses on their carry trades after being caught off guard, these investors and traders now feel beaten, bruised and betrayed by the central bank.
Bond market investors on the wrong side of the trade argue that the RBA “blew up” low rate investors, “smashed the market” and “cleaned up” fixed income investors with large positions.
The Australian composite bond index plunged 3.6% in October, the second worst month in 30 years, and a big monthly loss for fixed income securities, which are a defensive asset.
Without a doubt, some traders lost money, especially the leveraged traders who were successful on margin calls.
Turns in markets are often volatile, and professional investors are highly paid for managing risk and predicting the future.
Investors who had the patience to hold the bonds to maturity would not suffer a permanent loss, but rather only a temporary loss to mark-to-market, as the RBA currently supports on its bond portfolio of State.
Nonetheless, the real consequence is that mortgage borrowers and businesses are now paying higher fixed interest rates than they would otherwise be on new loans.
Almost a month after the market turmoil, the government bond market and the banknote swap market are suffering from liquidity problems. The lack of buyers and sellers in the market partly reflects a lack of confidence in the ability to assess future RBA policy changes.
Banknote swap rates – a benchmark for borrowing costs – have jumped.
The spread between the three-year swap rate and the three-year government bond yield exploded from 0.20 to 0.30 percentage points. Usually these rates are more closely aligned.
Deploying emergency easy money policies like targeting the yield curve and buying bonds is easier than exiting programs in an orderly fashion.
The expansion of swap rate futures is pushing up fixed borrowing costs for businesses, banks and homeowners.
A de facto rise in interest rates through a bond market revolt against the RBA spills over into the system.
In absolute terms, the rate on three-year banknote swaps fell from around 0.4% to 1.4%, due to a range of local and global factors.
Fixed mortgage rates have jumped in recent weeks, following the closure of the RBA’s $ 188 billion term financing facility.
Partly offsetting this, variable rates on home loans have come down as banks compete harder to hunt customers who are not stuck on fixed loans, and variable loans become more profitable compared to fixed loans.
About four weeks after the peak of the market disruption, bond market liquidity has not returned to its previous levels. The three-year government bond futures market has around 150 to 200 bids and bids, compared to around 1,000 to 2,000 in more normal times.
The appetite for risk has not returned after the large losses suffered by some funds.
Hedge funds often have investment protocols based on historical value at risk and liquidity risk measures. Their withdrawal had a ripple effect. As hedge funds have pulled out, other investors, such as banks, are also reducing their exposure due to a lack of liquidity to offload their trades.
Many economists and traders believe that there are too many interest rate hikes being factored in by the markets – four rate hikes in 2022. Yet they are unwilling to make big bets against the prices of the market. hawkish market and to support the conciliatory view of the RBA after being burned the last time.
A counterpoint to this conservative approach to investing is that investors and traders potentially leave money on the table and miss out on profits.
There are also other factors at play beyond the perception of the RBA market.
Global inflationary pressures pushed up short-term yields around the world, penalizing investors betting on a steeper yield curve. The US Treasury market is also suffering from a lack of liquidity.
Global banking regulations mean that market makers are less willing to take on intermediate risk.
Bond trading is not as profitable as it used to be, which means bond bureaus receive less capital allocated to them and have less ability to absorb risk.
The RBA’s abandonment of yield curve targeting has exacerbated these existing structural factors.
One lesson seems to be that it is easier to roll out emergency easy money policies such as yield curve targeting and bond buying than it is to exit programs in an orderly fashion.
A Swedish Riksbank study found that quantitative easing initially improves market liquidity, but once the central bank holds more than 40% of government bonds, liquidity deteriorates.
“In fact, the deterioration in the level of liquidity in the QE market via the scarcity effect is significantly more important than the improvement in the demand effect,” he noted.
The RBA now owns about 33 percent of the $ 800 billion federal bond market and more than 15 percent of state government bonds. It now buys more debt each week than the government issues.
Cutting its $ 4 billion-per-week bond buying program at the February board meeting is the next test facing the RBA and interest rate watchers.