Market insights and analysis by Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,
Yielding to “RORO”
The profusion of cheery relief led by dampened global bond yields and coinciding resurgence in equities (Dow: +2.0%; S&P500: +2.4%; Nasdaq: 3.0%) only reinforces our qualified appraisal of this situation as respite, not resolution (the title of yesterday’s edition of this publication). To be clear, your scribe is not dismissive of the relief. Especially insofar that policy makers such as the ECB, BoJ and RBA have stepped up to quell the rising tide in long-end yields.
But not every policy response is a resolution. Point being, obvious tensions between reflation and long-end yields (more sensitive to anticipated inflation) continue to fester; especially without explicit policy recourse such as YCC (yield curve control) or “Operation Twist”.
Crucially, the conspicuous absence of Fed action to explicitly anchor long-term rates suggests latent vulnerability to long-end UST yield volatility; with far-reaching global spillover. In other words, the Fed’s current state of play does not significantly negate susceptibility to outbursts of “risk off” catalysed by bond market (UST) tantrums.
Meanwhile, FX dynamics have been rendered more fragmented. While EUR remained under the weather around (and now below) mid-1.20, AUD regained some traction to above mid-0.77. USD/JPY surging towards 107, while USD/SGD is sticky downwards around 1.33.
This, as USD reaction function straddles yield differentials (sharper European yield pullback denting EUR), but is deferring mostly to sharp “RORO ” (“risk on-risk off”) markets.
Specifically, USD rises as the premier safe-haven on “risk off” seen late last week, and eases back on “risk on”. When UST yields are stable/softer amid “risk on”, this may appear to be a distinction without a difference. But when markets are spooked sufficiently and yields falls along with equities (and perhaps even commodities) the USD’s dominance despite softer yields is note-worthy.
Equally, higher UST yields on optimism on a “risk on” day may also correspond to a softer USD. Upshot is, a “RORO” USD, which is mostly a function of risk sentiments, may be the default.
The RBA’s Flex
To be clear, the RBA was expected to hold its horses in 2021 on improving growth prospects amid activity resumption, reflation commodity boom and a housing market that is heating up. Especially after the extension of QE (at current A$5bn/week pace) by another A$100bn.
But market volatility threatening to spillover into the real economy begs a response. Specifically, the RBA’s imminent and more serious challenge is to insulate against a brutal upswing in UST yields from unsettling Australian bond markets.
A lesser, now subordinated, issue is leaning against excessive and abrupt AUD surge from the commodity boom. The convenient silver lining is that these two challenges are mutually exclusive; in this case, with the US bond market upheaval taming AUD bulls.
But one way or another, the RBA must ensure that YCC and QE are likely to undermined amid global bond yield volatility. To that end,, flexing current policy may give the RBA far more latitude than rigid responses or instinctively reaching for “bigger guns. In particular, flexibility in the rendition comprising;
i) flexibility to front-load (A$5bn/week) QE purchases as needed as well as;
ii) flexibly target further out the curve (from current 3Y AGB target) for YCC.
This not only provide the RBA with the speed of response and an element of adaptability without binding commitments; but critically allows the RBA to address evolving challenges. Bets against the RBA under these circumstances are not compelling, and may prove AUD positive insofar as it is seen as enhancing policy efficacy and protecting a “Goldilocks” recovery.