Speech
The Reserve Bank's Operations - Liquidity,
Market Function and Funding
[*]
Christopher Kent
Assistant Governor (Financial Markets)
Address to KangaNews
Online - 27 July 2020
Introduction
In the early stages of the pandemic, there was extreme uncertainty about how much economic
activity would decline and how long the economic disruption would last. It was also uncertain how
much support would be provided by monetary and fiscal authorities. And so, as the virus spread
around the world through early March, extreme uncertainty and the prospect of a sizeable decline in
economic activity was reflected in financial markets globally. In particular, there was a sharp rise in
the volatility of asset prices, a decline in the prices of risky assets, and before too long, dislocation in
a number of key financial markets (Graph 1). Most notable were the problems affecting government
[1]
bond markets, which are critical to the pricing and operation of financial markets more broadly.
Australia was no exception.
Graph 1
These conditions underpinned a general rush for liquidity, including by banks and other financial
institutions. More generally, investors in a wide range of financial markets also sought to shore up
their liquidity and reduce their exposures to riskier positions.
In reaction to this increase in the demand for liquidity around the world, central banks increased the
supply of liquidity as part of a broader policy response to support their economies (Graph 2). They
provided that liquidity initially by scaling up their open market operations. Central banks also bought
government bonds in secondary markets. They did this with a view to restoring more normal
functioning in those markets, but it also had the effect of providing additional liquidity to those
selling the bonds. Furthermore, a number of central banks started new facilities, or extended existing
ones, to provide longer-term funding to banks at favourable rates.
Graph 2
Central banks that had room also cut policy rates. In many cases that was accompanied by forward
guidance that policy rates would remain low for some time. Some pursued quantitative easing (or
'QE'), whereby they committed to buying particular quantities of government bonds (and in some
cases other assets) over and above what was required to restore market functioning. Rather than
announcing a quantity target, the Reserve Bank opted for a yield target, whereby we stand ready to
buy Australian Government Securities (AGS) so that the bond yield at the 3-year mark stays around
25 basis points. To be clear, our 3-year yield target applies to the bond with residual maturity closest
to 3 years (as opposed to the futures basket). That means that the focus of our target will shift from
the April 2023 bond to the April 2024 bond later this year.
In what follows, I'll focus much of my attention on the details of our operations affecting liquidity,
market function and term funding. I'll finish by considering the implications of these various
developments for conditions in markets for fixed income securities.
Liquidity
In response to the sharp rise in demand for liquidity from the banks in early March, the Reserve
Bank began to increase the supply of liquidity to the banking system via our normal daily open
market operations (OMOs). For a time, this was done by dealing more liquidity than our announced
intentions (in Graph 3, this is seen by the orange 'filled' orders bar exceeding the blue 'dealing
intentions' line). By mid March, this increase in the amount dealt had become very substantial, and
[2]
we began offering longer terms on a regular basis.
Graph 3
By the latter part of March, liquidity in the banking system - as measured by banks' Exchange
Settlement (ES) balances held at the Reserve Bank - rose even further. This was a result of the
Reserve Bank's purchases of government bonds in secondary markets to help achieve the yield
[3]
target on 3-year AGS as well as improve the functioning of government bond markets. By the
early part of April, take-up of the Term Funding Facility (TFF), also part of the Reserve Bank's policy
package, was adding further to banks' ES balances.
By mid April, there were signs that the increased supply of ES balances had met the surge in
demand for liquidity in the banking system. This was evident in the sustained drop in the amounts
dealt at our morning auctions. Financial conditions more broadly had also become more settled.
Graph 3 shows that we had switched our approach in our OMOs over this period. Previously, we had
targeted a particular level of ES balances and used the price (i.e. the repo rate) to determine which
counterparty bids were filled (and which were unfilled). Lately, we have been meeting the demand of
banks that present at auctions at a steady repo rate.
Given the high level of ES balances supplied by the Reserve Bank, it was not surprising that the cash
rate fell below 25 basis points (Graph 4). Since the latter part of April, it has generally been either
13 or 14 basis points. Daily volumes of cash transactions between banks have declined, since many
banks don't need to borrow overnight from one another given the relatively large balances they each
have in their ES accounts. Indeed, on some days there have been insufficient volumes to calculate
the cash rate based on market transactions. On these days we have instead used expert judgement
as set out in our fall-back procedures to determine the published cash rate. These fall-back
procedures ensure that we can continue to publish the cash rate. Typically, we have used the last
published rate based on sufficient market transactions. But there has been one occasion when we
[4]
published another rate that we judged to have better reflected recent market conditions.
Graph 4
One thing we are continuing to do as usual during our regular operations is to buy back AGS that are
near to maturity. This is done in order to reduce very large swings in the supply of ES balances that
would otherwise occur on days when a large bond line matures. These buy-back operations occur
either via our OMOs or bilaterally. They are conducted separately from the purchases at auctions for
[5]
the purposes of hitting the target for the 3-year AGS yield and to improve market function.
The low level of the cash rate and the high levels of liquidity provided by the Bank have contributed
to low rates in other money market instruments, such as bank bills (Graph 5). For some time now,
3month and 6-month bank bills have been trading around market expectations of the future cash rate
(i.e. the OIS rate).
Graph 5
So the actions of the Reserve Bank have contributed to historically low funding costs for banks. Also,
banks have benefited from an influx of low-cost deposits. Some of that has come from businesses
that tapped their lines of credit but then left those funds on deposit. There are a number of other
reasons for the increase in bank deposits. This includes increased spending by the Australian
Government (net of taxes), which leads to funds being paid out from the government's account at
the Reserve Bank to customers of commercial banks. The purchase of government bonds by the
[6]
Reserve Bank from non-banks has the same effect.
Market Function
A number of key financial markets became dysfunctional through early March, including the critical
markets for AGS and semi-government securities (semis). This was recently discussed by my
colleague Guy Debelle, so I'll just provide a short summary of some key points before turning to the
mechanics of these operations.
The substantial fall in risky asset prices in early March underpinned a sharp increase in financial
market volatility more broadly. This meant that a range of investors needed to sell assets to reduce
leverage, cover margin calls, and meet redemptions. Many investors sold government bonds and it
didn't take long before dealers were unable to absorb more of the one-sided flows, including because
of their own internal risk limits. Hence, we faced the extremely unusual situation whereby prices of
bonds that they reference (Graph 6).
Graph 6
Given that the underlying cause of the market dysfunction was an urgent need to sell bond holdings
and raise cash, the Bank decided to step in and provide the market with some liquidity. We did this
by offering to buy government bonds at auctions. For each auction, we announced the amount we
would purchase, which particular bond lines we would be willing to buy, and let counterparties bid to
sell those bonds to us. The bonds we actually bought within that suite depended on the bids at
auction, whereby we purchased those at the lowest possible prices (highest yields).
The choice of which bonds we offered to buy, and the overall amount, was informed by a number of
sources including liaison with market participants, the AOFM, and the state and territory government
borrowing authorities. We also assessed the extent of dysfunction based on some of the indicators I
[8]
mentioned earlier, including which bonds appeared most mispriced. The auction results
themselves were also informative for subsequent auctions. For example, at some auctions we
received a lot of offers to sell bonds, and those offers were priced 'to sell' (that is, they were offered
at yields above mid-market levels). That was a good indication that there was an excess stock of
bonds in that segment of the market clogging up dealer balance sheets. In such cases, we
conducted further auctions in that part of the yield curve within quick time. On the other hand, if an
auction did not receive that many offers, or the pricing we received was relatively unattractive, this
indicated that there was no large supply-demand imbalance and, therefore, no pressing need for
further auctions in that part of the curve.
The Bank's purchases have had the intended effect: as we purchased bonds the imbalance of supply
and demand was redressed. This was evident in a decline over time in the volume of attractively
[9]
priced offers to sell. It was also evident in other measures, including bid-offer spreads, mispricing
along the yield curve, and the ability to trade in futures without moving the price. These all
improved, to be close to pre-crisis levels. The general improvement in financial sentiment - aided by
the range of other policies, both monetary and fiscal - is also likely to have played a role. In any
case, since late April we have scaled back purchases significantly and have not needed to purchase
any bonds for some time. We stand ready though to buy bonds if bond market conditions deteriorate
significantly, or indeed, if needed to achieve the target of around 25 basis points for the 3-year AGS
yield.
Term Funding
Another initiative from the Bank was the Term Funding Facility to lower borrowing costs and support
lending, particularly to businesses. The TFF does this by providing a guaranteed source of funding to
ADIs for 3 years at the low cost of 25 basis points, with an incentive to increase lending to
businesses, especially small and medium-sized enterprises (SMEs). Funds provided under the TFF are
secured against collateral, as is the case with the Bank's other facilities.
The TFF provided banks with the option of an initial allowance of around $90 billion. This has since
grown to around $150 billion, with additional allowances granted to individual banks that have
increased their lending to businesses since the facility began in April.
Take-up of the TFF is currently around $26 billion, or around 17 per cent of the total currently on
offer (Graph 7). There are a few reasons why banks have not taken up more of this funding at this
stage in the program. One is simply that many banks have accessed even cheaper funding from
other sources in recent months, albeit at shorter tenors than three years. In particular, banks have
been able to issue bank bills at rates below 25 basis points. Similarly, bank deposits have grown, and
an increasing share of deposits have been paying rates below 25 basis points. Also, the TFF provides
funding for three years from the date of the drawdown, so the longer an ADI waits to draw funds,
the later they will have to repay the money. With no pressing funding need right now, and ample
alternative short-term funding at low cost, delaying the drawdown is a useful option.
Graph 7
The calculus underpinning the decision of some banks to delay drawing on their initial TFF allocations
will change closer to the deadline of 30 September. At that time, it will make sense for banks to
compare the certain 25 basis point cost of the TFF with the uncertain cost of other sources of
funding over the next three years, including bonds that would mature over that period. So our
expectation and liaison with the banks suggest that the take-up of the TFF will ramp up as we get
closer to the end of September.
Despite only part of the funding being drawn down to date, it's worth noting that the TFF -
combined with the Bank's other policy measures - has already had a significant impact. On the
funding side, the ability to draw on the TFF means that banks can be selective in how they raise
money, and this has contributed to overall bank funding costs falling by around 60 basis points since
February. And on the lending side, we have seen interest rates on new fixed-rate mortgages fall by
around 65 basis points since February, and rates on SME loans fall by around 60 basis points.
Private Sector Fixed Income Markets
I now want to turn my attention to what all of these developments imply for private sector fixed
income markets.
Like government bond markets, private sector fixed income markets also became dysfunctional in
March. These markets were significantly disrupted for a time as concerns and uncertainty about the
economic and financial effects of the pandemic rose sharply. Issuers typically try to avoid going to
market with new bonds at such times, given the very high premiums demanded by investors,
particularly if they have the option of waiting because they are already well funded or have other
funding options. However, with the aid of monetary and fiscal policies, it did not take too long for
financial conditions to settle and fixed income markets to 'reopen'. Issuance though has varied
considerably across different types of issuers.
The major banks have let their existing bonds mature without replacement, so their issuance has
declined in net terms, and they have not issued any residential mortgage-backed securities (RMBS,
Graph 8). This is not surprising given a number of forces at work. First, with credit growth likely to
remain low or even decline, their funding needs will remain modest for a time. Second, they had
issued quite a lot of bonds prior to the pandemic and have subsequently found themselves flush with
other sources of funding, including low-cost deposits. While those sources do not have the same
maturity profile as longer-term bonds, they lessen the need for near-term issuance. And third, they
have the option of accessing funds from the TFF at a cost of 25 basis points, while the cost of a
newly issued bond of similar maturity is around 30-60 basis points (based on secondary market
prices in recent weeks).
Graph 8
Other, smaller banks, have issued bonds over recent months. In part this reflects the fact that they
haven't benefited to the same extent as the major banks from an influx of deposits. But in any case,
their issuance is roughly offsetting maturities so in net terms issuance isn't increasing. Similarly,
mortgage originators have resumed issuance of RMBS over the past few months, following a pause
in April. The AOFM has supported this by purchasing RMBS directly at issuance, and in the secondary
[10]
market (with investors then recycling those funds into new primary issuance). Spreads at
issuance are a little higher than they were at the start of the year, but do not stand out when taking
a slightly longer perspective (Graph 9). And yields are at low levels, driven by the fall in BBSW rates.
Graph 9
Over the year to date, non-financial corporations have been issuing bonds to about the same extent
as they have in recent years (Graph 10). After a period when markets were disrupted during the
height of the market stresses in March, these firms have been able to issue bonds in good quantities
and relatively favourable yields, which is welcome (Graph 11). The relatively low level of yields
reflects the historically low level of risk-free rates, with 3-year AGS yields consistent with the Board's
target of around 25 basis points. Also, spreads on corporate bonds are relatively low. Spreads in
secondary markets rose earlier in the year in response to fears about the health of the business
sector, but have eased somewhat since then, aided by significant support provided by monetary,
fiscal and prudential policies.
Graph 10
Graph 11
Finally, many large firms also tapped their credit lines at banks in March and April, providing a
significant boost to business credit. Part of that appears to have been precautionary given that firms
have repaid some of their revolving facilities more recently. Another source of funding has been the
very substantial issuance of equity in recent months by a wide range of listed firms. Those
companies raising equity cited the desire to strengthen their balance sheets, and in some cases to
pursue opportunities for growth.
Conclusion
In response to the severe impact of the pandemic on economic activity and financial markets, the
Australian authorities have provided unprecedented support, including via fiscal, monetary and
prudential policies. Monetary policy has been focused on supporting the economy by keeping the
cost of borrowing low and helping to maintain the supply of credit to households and businesses.
To help achieve these ends, the Reserve Bank has undertaken a number of significant operations.
First, it responded to the sharp rise in the demand for liquidity by the banking system by scaling up
its daily open market operations. It met the demand for liquidity from banks, providing that at longer
terms, against high-quality collateral. Second, the Bank provided much needed liquidity in a different
manner, by purchasing government bonds outright at a time when there were plenty of sellers and
very few buyers in those critical markets. And third, we provided the option of low-cost funding to
banks by rolling out the Term Funding Facility. While we refer to this as funding, it is liquidity
provision by another name - the banks obtain cash, for three year terms, by posting collateral. So
while these operations are novel in some respects, in many ways they can be thought of as
representing the 'bread and butter' of central banking - providing liquidity to meet demand at a time
of considerable need, thereby acting to stabilise crucial markets.
From my perspective, these operations have worked well. Along with other monetary, fiscal,
prudential and health policies, they contributed to a noticeable improvement in market sentiment
and accommodative financial conditions. Among other things, we clearly see the effect of that in the
ability of firms to gain access to a wide range of funding, at low rates, including in fixed income
markets.
Endnotes
rate-methodology/cash-rate-procedures-manual.html. These procedures allow for the cash rate to continue to be
published, including in the absence of market transactions, and allow for changes in the benchmark design in
response to market conditions to ensure that the cash rate continues to reflect the interest rate relevant to
unsecured overnight funds.
[5] Statistical Table A3 contains data on such purchases; see https://www.rba.gov.au/statistics/tables/xls/a03.xls.
[6] The purchase by commercial banks of the bonds of the states and territories also contributes to a rise in bank
deposits since the states and territories hold their accounts with commercial banks, whereas the Federal
Government holds their accounts at the Reserve Bank.
[7] For further details see Finlay R, C Seibold and M Xiang (2020), 'Government Bond Market Functioning and
COVID19', RBA Bulletin, September.
[8] See Finlay R, C Seibold and M Xiang (2020), 'Government Bond Market Functioning and COVID-19', RBA Bulletin,
September.
[9] As market function improved and the supply-demand imbalance lessened, the Bank reduced the size of its auction
operations, and it is possible that this reduction may also have contributed to the fall in attractively priced offers to
sell bonds.
[10] For further details see <https://www.aofm.gov.au/sfsf>.
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