Asian central banks walk on the wild side

Asian central banks along with the Reserve Bank of Australia have taken a walk on the wild side with their shift into unconventional monetary policy. Will anything ever be the same again for bond investors?

Seeking to conquer deflation, the Bank of Japan has run various quantitative easing programs over the past two decades, with current efforts focused on a “price stability target” of 2 per cent.

The Japanese central bank is currently targeting a short-term policy rate of negative 0.1 per cent and a long-term rate of zero, while buying billions of yen of assets including exchange-traded funds, real estate investment trusts, commercial paper and corporate bonds.

With headline inflation turning negative in April for the first time since 2016 amid a deepening recession, the BOJ likely will keep policy ultra-easy for some time to come, particularly given the continued threat of COVID-19.

But other Asian markets have also strayed into unconventional territory.

Central banks in Indonesia, Malaysia and the Philippines have each cut their respective reserve requirement ratios for bank lending. And India’s 100 basis point reduction of its cash reserve ratio in April was the first in nearly seven years.

Unlike previous measures, “the explicit objective of the reserve requirement reduction in each of these economies has been to augment liquidity,” according to an ANZ Bank report from 19 May.

Other unconventional measures have included:

• Bank of Indonesia taking part in government bond auctions in the primary market
• Bank of Thailand buying corporate bonds from mutual funds
• The Philippines central bank buying government bonds in a six-month “repo” transaction.

“The current monetary policy matrix has indeed turned unconventional, at least by Asian central banks’ standards,” says Sanjay Mathur, ANZ’s chief economist, Southeast Asia and India and economist Rini Sen.

The economists attribute the policy shift to a need to stabilise financial markets. This has seen an “unprecedented” scale of foreign portfolio outflows and redemptions on local mutual funds, combined with supporting fiscal stimulus efforts ranging from 6.2 per cent to 11. 8 per cent of gross domestic product in South Korea and Thailand, respectively.

Another goal of this stimulus is to increase the confidence of banks and other financial institutions who lend to the corporate sector, particularly SMEs.

These QE programs differ from those employed in the United States, European Union and Japan after the 2008-2009 financial crisis, when the key aim was to boost low growth and inflation when interest rates were already near-zero.

But the ANZ economists argue Asia’s unconventional policies won't have much effect either way, good or bad.

“The region is not experiencing any excesses, and neither is the scale of liquidity injections large enough to engender macroeconomic instability,” say Mathur and Sen.

“At the same time, we should not expect this policy stance to reflate growth in the near term.”

London-based research firm Capital Economics expects further rate cuts in Malaysia, Sri Lanka, India and the Philippines. Their central banks have already cut rates by at least one percentage point since the start of the year, although Indonesia has taken a more gradual approach amid fears of a sharp fall in its currency.

Elsewhere in the region South Korea, Taiwan and Thailand are also tipped to adopt QE programs, but have limited room for further conventional easing as their cash rates are already near zero.

Asia’s moves follow the RBA’s March step into unconventional territory, with the central bank setting the targets for the cash rate and the yield on three-year Australian government bonds at 0.25 per cent and buying around $50 billion worth of bonds as at 2 June “to ensure bond markets remain functional and to achieve the yield target”.

‘This makes us very uneasy’

What are the implications for fixed income investors?

John Likos, director, investment management at BondAdviser, suggests the extra liquidity measures by central banks globally will exacerbate yield compression, intensify the search for yield and increase the potential for negative interest rates, including in Australia.

He says investors are now buying bonds not for their yield potential but for their capital appreciation and their sensitivity to interest rate moves.

“With the nationalisation of bond markets, price discovery has almost gone out the window. It’s become a case of forget value, forget fundamental analysis, just buy whatever’s there as the Fed and other central banks are buying it,” Likos says.

“This is something that makes us very uneasy.”

Given the potential of long-lasting effects from COVID-19 including a possible second wave, higher unemployment and lower consumer spending, Likos warns investors to be cautious.

“You have to continue to stick with quality. There’s a lot of FOMO [fear of missing out] driving the market now, but people should take a lesson from March,” Likos says.

“How is your portfolio protected from these one-off events, as they will happen again. And if you’re just chasing the rally and buying risk, you’ve really not learned anything”.