Australians have a global reputation for all sorts of things — financial upsets aren’t one of them. And yet, the Australian bond market might prove to be the canary that dropped dead in the bond market.
This sign could cause a global panic as the rest of the world wakes up to the potential for their own bond market chaos. Not every nation would be able to weather such a shift.
Unfortunately, the mechanics of this are a little complex. But they could be as important as subprime mortgage securitisation proved to be in 2007. So let’s dig in…
First up is the market action. On Thursday, Australia’s two-year bond yield more than doubled after the Reserve Bank of Australia declined to buy two-year bonds.
What does this mean? If the Australian government were to borrow money for two years, the interest rate they’d have to pay doubled in a single trading session.
Can you imagine if your mortgage rate doubled?
How rare is this doubling? ZeroHedge calculates it’s a five-sigma move, which is supposed to happen one day in every 13,932 years. In other words, it’s the biggest surprise for the Aussie bond market since the Lehman crisis.
What’s the explanation for why it happened?
Well, Australian bond yields have been rising recently, and fast. Traders expected the RBA to intervene by buying some of the bonds and stabilising the market. When they didn’t, the sell-off turned into a rout.
This signals a change in the policy to enforce stability during the pandemic. The RBA had promised to keep a lid on bond yields during the crisis to support government spending.
The implications are that if the two-year bond yield is not being pegged anymore, neither are other bonds. And that implies higher interest rates might be imminent.
Now, remember that a huge swathe of mortgage borrowers were promised that rates wouldn’t go up until 2024. Neville Norman criticised this promise in the Australian Financial Review in June:
‘The Reserve Bank of Australia’s (apparent) promise not to raise interest rates within its control until 2024 may go down as one of the most limiting, and damaging, public-policy pronouncements, ever.
‘Limiting, because it ties the hands of our main maker of interest rates, constraining its policy responses to future unknown developments, for at least 2½ years ahead, by its own (avoidable) words.’
The bond market action suggests that the RBA is untying itself in preparation for breaking its promise.
How do you think Australian mortgage borrowers will fare at the prospect of interest rates rising when they were promised they wouldn’t?
The impetus for the uncertainty is inflation, which is surging globally. Central banks are supposed to tighten policy to rein in inflation. But it seems that governments rely on loose monetary policy to finance their deficits.
Which will the central bank prioritise — financing government or fighting inflation?
But the bigger story is international, depending on whether the Australian bond market is a sign of what’s to come elsewhere. Because, if it is, then governments that aren’t in a stable financial position could go bust as rates rise.
And they might not be the only ones…
I’m working on a video that explores why central banks can’t just buy all the debt that’s weighing the global economy down. Why can’t they just buy all the government debt and solve the problem of too much debt?
You’ll have to wait for the video to get an answer. But preparing it has raised another interesting question that may be playing out at the RBA.
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Can central banks go bust?
Because of their vast quantitative easing programs, central banks now own huge piles of assets. Especially government bonds. But as interest rates rise, the value of those bonds falls.
If you or I hold assets that fall in value, we can get into trouble. If it happens to banks, they can get into big trouble. What happens to the central bank in this scenario?
If the value of the assets that central banks buy goes down, the central bank itself could technically be broke.
But it’s not clear what that actually means, because the central bank is such an odd institution that sits outside the economy. What rules apply to it?
Well, that varies between different countries. But I’m not especially interested in the rules, because they can easily be changed — and they usually are in a crisis.
In the upcoming video I’m making, Jim Rickards of Strategic Intelligence Australia describes what happened when he asked an American central banker about the Federal Reserve going broke.
The response was…well, you’ll have to wait for the video. But I will reveal a little here…
If the value of the assets held by the central bank goes down, the central bank’s capital would be wiped out, just like a bank’s capital would be wiped out if enough people default on their mortgages.
But remember, the central bank sits outside the economy. It’s not clear whether it would matter if the central bank was ‘trading insolvent’. They aren’t subject to the same rules as the rest of us.
For example, as Jim Rickards explains in the video, they are not subject to ‘mark-to-market’ rules that compel hedge funds to check daily that their assets are worth more than their borrowings.
It’s worth mentioning that in some nations, under the current laws, the government could be forced to invest money into the central bank if the value of its assets were to fall too far. The UK is one example. But whether this needs to happen is not clear. And rules can change…
What we’re really talking about here is whether to turn central banks into a ‘bad bank’. This was the Irish solution to the 2008 crisis. The bad bank bought the dodgy assets and thereby helped the rest of the banking system.
Central banks can create money out of thin air, so they’re a rather good ‘bad bank’.
Whether or not a central bank can go bust — and whether central bankers will choose to prioritise inflation or financing governments — isn’t known yet. But what we do know after Thursday’s bond market trading session is that Australia might find out first.
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
PS: Our publication The Daily Reckoning is a fantastic place to start your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here.
