How the RBA’s attempt to control yields has impacted the bond market
A decision that was made to ensure Australia stayed afloat during the pandemic is now wreaking havoc in the economy.
Throughout history, humanity’s attempts to tame things and bring them under our control has been a consistent driver of technological and social development.
From the first domestication of canines, all the way through to the harnessing of millions of tons of rocket fuel to jet us into space, we have already reached for that next horizon, even if sometimes it quite literally blew up in our faces.
But after millennia of achievements, there is still something that often finds a way to trip us up, the unpredictable realities of human nature.
This brings us to the recent failed attempts by the Reserve Bank to control something that may be untameable, Australia’s trillion dollar government bond market.
The bond market
Through the bond market, the federal government and the states and corporations borrow money from investors in order to fund projects or simply to pay their bills.
The interest rate or yield on the debt is determined by what rate the market (investors) is willing to lend at, based on the risk of the investment, the expected rate of inflation and a number of other factors.
By design, bonds are meant to be a liquid asset, as in they can be bought or sold with relative ease within a well-established and regulated market.
Due to this ease of transactions, they are traded often and the price can fluctuate significantly even over the course of a single day.
While the interest rate payable by the originator of the bond, say the federal government, remains the same across the life of the bond, the interest rate receivable by a potential bond buyer can vary based on the price when they bought it.
In the same way that the yield changes on an investment property when a new owner buys it for a higher price when the rent stays the same, so too the yield of a bond changes depending on its price when it changes hands.
The RBA tries to fix the game
At the height of the financial market upheaval in March of last year, the RBA announced that it was going to introduce yield curve control.
In plain English, the RBA committed to buying a specific government bond due to be repaid in April 2024, in order to ensure that the yield on the bond never significantly exceeded 0.25 per cent per annum.
By doing this the RBA attempted to ensure that the short term borrowing costs of the federal government and the states would be pinned to that 0.25 per cent rate for the duration of that bond, giving them substantial room to borrow money to fund the pandemic stimulus packages.
But government wasn’t the only beneficiary of the RBA’s attempts to fix the game.
By committing to ensuring bond market funding costs remained low, they also ensured that the banks could fund mortgages at these low rates for years to come.
In November 2020, the RBA revised down its target to just 0.1 per cent, effectively ensuring that short term borrowing costs would remain roughly at…
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