How the US and Australia have influenced the bond market during COVID-19

By: Susan Tang & Ellison Zhou

Posted: 28th April 2020

The COVID-19 pandemic has created ensuing impacts on financial markets. Both central banks, The Fed and Reserve Bank of Australia, have been in tandem with their monetary policies. They have reduced interest rates in expectation of stimulating the cash flow of businesses and reducing exchange rate risk for trade-exposed businesses. In the bond market, monetary policy has been enacted through quantitative easing, which involves the purchase of government bonds in the secondary market to increase the money supply in the market, encouraging investment and spending. Bonds can provide a strong indication of an economy’s performance. A common example is the 10-year US Treasury Bond, which is seen as one of the safest, most liquid assets in the world. When investors start to become fearful, there is a tendency to buy these securities, pushing down Treasury Bond yields and causing the yield curve to invert. This has been evident in light of the COVID-19 pandemic. On top of this, both country’s government stimulus packages have revealed difficulties in financing debt. Domestically, we wave goodbye to the budget surplus and over in the US, the bond market is struggling to save its economy.

So how does Australia and the US plan to combat this? Let’s look at this from an economic perspective in Australia and the specific consequences for the bond market in the United states.

Interestingly enough, both countries have taken relatively similar approaches. In Australia, the Reserve Bank of Australia has targeted a three-year bond yield at the overnight cash rate of 0.25%. The RBA, under its quantitative easing program, will purchase an “unlimited” number of government bonds in the secondary market to maintain the three-year bond yield at 0.25%. To paint the picture, let’s look at what this means for Australia’s economy. Essentially, when the RBA purchases these government bonds from banks and pension funds, this increases the supply of money for these institutions. With a greater money supply, this allows banks to lend more readily to businesses and consumers, ultimately resulting in more economic activity. But where does the government get the money from? Printing money.

So does this create debt issues for the government? Let’s use the concept of Modern Monetary Theory (MMT) to explain. The Modern Monetary Theory (MTT) is an idea that countries and households are not alike. As long as the debt is denominated in the home country’s currency, the country cannot run out of money in the way a business or person can as they are able to print more money to pay the debts. At first glance, it would be intuitive to recognise that there could be the possibility of hyperinflation if the government could print any amount of money, just like in 1920s Germany where a wheelbarrow of cash bought a loaf of bread. If we look at it from an economic perspective, inflation occurs only where the aggregate demand is greater than aggregate supply, that is, when there is not enough goods and services for the economy to purchase. As long as the economy is able to keep producing goods and services, the rate of inflation will remain relatively stable. Only in high levels of employment would it be difficult to meet the extra demand as it would be hard to increase levels of production. In this COVID-19 pandemic, Australia has been plagued by high levels of unemployment, and therefore this would not be an issue. So ironically, as long as inflation is not an issue, the Australian government is able to spend freely. So it really is a misconception that our role as taxpayers is to pay for government spending. Rather, taxes are a way of managing inflation. Believe it or not, the government is creating money on whatever it decides to spend on.

Let’s look at what quantitative easing has done to US bond markets. Similar to Australia, the Fed has promised to purchase an unlimited amount of government bonds. Previously, the Fed was limited in only buying extremely safe Treasury bonds and government-back mortgage bonds. But the Fed’s approach has since changed during the COVID crisis, as they will now extend to purchasing corporate bonds. This includes bonds from companies who directly issue them, corporate bonds already trading in the secondary market and exchange traded funds (ETFs). What are the consequences? Well, buying any type of corporate bonds exposes the Fed’s balance sheet to credit risk. Credit risk is the possibility that some of the bonds which the Fed buys may default and/or suffer a severe loss of value. Why is this a problem? If you look at treasury bonds there is no credit risk because the government can always print money. Now let’s look at an example of Ford, a “junk bond”, which felt the full force of the COVID pandemic, trading at a deep discount from 120 cents to 68 cents on April 8th. Instead of being able to print money, Ford has to earn money to cover its debt, and therefore be profitable over the long term. By purchasing Ford’s corporate bonds, the Fed is essentially taking on Ford’s operational and strategic difficulties. This type of risk is challenging for the Fed. Why? Because the Fed is not accustomed to evaluating individual companies. For example, in 2008, the Fed had to take on risky assets including AIG and turned to BlackRock, one of the world’s largest asset management firms for assistance. They made be needed to do so again in light of the pandemic.

With households struggling and needing financial assistance more than ever, the Federal Government’s stimulus packages announced last month seems like a sigh of relief for everyone. However, this money is not coming out of thin air, and essentially, there needs to be a means for the government to finance this. Unfortunately, the hard work in bringing the budget back to surplus will be undone due to this pandemic.

Morrison’s total $213.7b stimulus package dwarfs the Rudd’s Labor government stimulus package during the 2008-10 GFC, which saw Australia’s net debt rise from -$22.1b to -$159.6b. So what does this mean for us in 2020? Well, to put it into perspective, the Rudd government package left Australia in a debt-to-GDP ratio of 10.4%, whereas the Morrison government package is projected to leave Australia ‘s debt-to-GDP ratio at 26%.

This leaves the Government in a tough position and will require borrowing money. This money will be financed via the Australian Office of Financial Management (AOFM) which borrows money for the Government by selling Australian Government bonds. Those who buy these bonds are institutional investors (foreign and local banks) that promise the repayment of this principal amount at a later date, with regular interest payments meanwhile.

But, the main buyer of these bonds will be the Reserve Bank. With the cash rate at a historical low of 0.25%, the Reserve Bank will be aiming to keep it as low as possible in hopes of saving the economy from sinking into the depths of a recession.

What’s interesting is that Australia is currently recording the biggest bond sale in history. This leaves the question: other than the RBA, who really has no choice but to keep us afloat, who would want to buy bonds during the economic uncertainty around this pandemic? The truth is, bonds are lower in risk than other investments, such as stocks. Most people that are investing in bonds are retirees who need a predictable source of income, which government bonds can offer through high levels of liquidity and security. Of course, with the economy hooked up to the Morrison government’s stimulus ventilator, the situation now may not look favourable. However, in three yield to maturity, this can hold promise for good returns.

Over in the US, the situation looks grimmer. Under the CARES Act, 88 million Americans have received money as part of the $2 trillion financial stimulus package. With more plans to come to keep American jobs alive, a rhetoric we are all familiar with by President Trump, the swing of future stimulus packages is projected to place their federal budget in a deficit of -$3.7 trillion.

The $17 trillion US Treasury market is already recently facing a liquidity crisis, with structural problems being uncovered. This equates to more intense volatility and makes it costly for the government to sell bonds. While the stimulus packages will look more dramatic in the near future, stress is placed onto the government in their attempts to sell the bonds.

So far, there have been strong demands for Treasury Bills, however, those are the ones with the shortest maturity. Longer-dated debt has also picked up in sales, but the risk is the government needs to pay higher yields to sell this debt, especially when the greatest economic hit is yet to come. Sales from foreign investors and foreign banks have already reduced purchases at auctions in March in anticipating higher volatility rates.

However, there is some light at the end of the tunnel. As the US continues to battle with the economic slowdown as a result of COVID-19, the Federal Reserve has bought more than $2 trillion in bonds since February. This action is echoed in Australia, with attempts to stabilise market conditions.

There is no doubt that COVID-19 has infiltrated through the lungs of the world’s economy. Central banks from both Australia and the US are desperately trying to keep their respective cash rates low in order to stimulate the economy. Quantitative easing and stimulus packages both serve as a temporary ventilator, but the road to recovery will be a tedious one.