But on March 13, Nicholl’s worst nightmares came true.
Mutli-billion-dollar hedge funds led a rapid-fire liquidation of Australian bonds as the sudden market shock of the coronavirus crisis blew up their carefully calibrated but highly complex trades.
With more bond sellers than buyers, prices crash and the yield or cost of borrowing shoots up.
“Once the market reactions gathered momentum, we were stunned at the speed and ferocity that liquidity for our bonds was hit,” Nicholl tells The Australian Financial Review.
“Every alarm was going off and it was difficult to quickly grasp the severity of what has happening,” he says.
Nicholl had some idea this was coming. Less than a month beforehand he made reference to such a possibility by way of a Hollywood movie series.
“Those of you familiar with the Die Hard movies starring Bruce Willis as John McClane will get the picture. But I could be wrong – maybe John McClane jumps to an adjacent skyscraper just as his tormentors blow it all up from beneath him,” Nicholl said in his prescient speech.
This movie has only just begun.
In times of crisis, investors don’t usually sell government bonds, they buy them instead because they are regarded as safe haven investments. But that’s not what ended up happening in this crisis.
Initially, as COVID-19 spread investors starting buying bonds. The 10-year bond price soared and the yield plunged to 0.61 per cent on March 9 from 1.25 per cent just a month earlier.
But then something strange began to happen. The buyers suddenly dried up.
Government bonds got dumped. Yields sky-rocketed.
The scramble was not for the safety of sovereign bonds, but an indiscriminate liquidation, by complex and highly geared trading strategies and global bond funds that were facing mass redemptions.
A sharemarket crash is bad enough, but a breakdown in bond markets that governments including Australia rely on for funding is as close to a financial market emergency as one can contemplate.
That’s why it was so important that Nicholl, as chief executive of the Australian Office of Financial Management, did foresee it.
The AOFM is the public agency that carries out the task given to it by government in raising the bonds required to fund its deficit.
While the government decides through the budget how much debt the nation needs to raise, the AOFM handles the task, managing how much to issue, when and in what form, while engaging with the market.
Last June, his head of investor relations, Ian Clunies-Ross, filled in for an unwell Nicholl at a gathering of economists in Sydney.
The presentation, titled Tough Times, Easy Task, was largely procedural – running through the details of how the agency would meet the government’s $60 billion funding task. But he repeated a warning from a year earlier that there were enough warning signs to lead him to believe investors will not always be there to buy his bonds.
“That reinforces our base-case thinking, which is to exercise humility as the rule rather than as an exception,” Cluiness Ross said.
Friday the 13th was a time for humility as hedge funds unwound their trades, while pension funds too prepared to offload bonds to manage redemptions in an all-out scramble for cash.
Initially investors were selling anything risky. Now they were selling anything they could. Incredibly, Australia’s one-year bond yielded almost 0.6 per cent, implying a cash rate increase before the year was out.
The panic in the bond market had focused the minds of Martin Place that had been watching with a growing sense of unease.
In usual times, rates in the bond market are meant to reflect the intentions and actions of the Reserve Bank of Australia well into the future. The yield curve, which plots government bond rates across various maturities, is also meant to set the risk-free rate across the economy, upon which all financial assets are valued.
But the broken signal was that rates would head higher and borrowing costs would rise.
There was little secret the Reserve Bank was preparing to cut rates and embark on some form of quantitative easing – where it buys government bonds with the intention of lowering long-term interest rates across the economy.
But a more immediate concern was that the bond market was not functioning properly.
On March 16, hours after the US Federal Reserve announced a dramatic interest rate cut, the Reserve Bank announced it would intervene as a buyer to fix the bond market, while planning a policy meeting on Thursday.
There it was widely tipped to cut the cash rate to 0.25 per cent and announce further intentions to purchase bonds.
It was the first time in history that the Reserve Bank had been prepared to buy government bonds, and its move temporarily restored some order to the bond market as the 10-year rate drifted from 1 per cent to 0.8 per cent.
But by London open, the buyers retreated as yields lurched higher. By Thursday, just hours before the Reserve Bank was expected to announce a cash rate cut and a plan to pin down yields by stepping into the market to buy bonds, yields were rising not falling.
On Thursday at 2.30pm, the announcement came. The Reserve Bank would cut the cash rate of 0.25 per cent and target a three-year bond rate at that level to provide confidence.
The central bank had proudly avoided what their larger peers felt they had no choice to do when interest rates hit zero.
But they envisaged the day might come when they would have to open their own QE playbook.
And while the RBA had prepped the market last year that it would be prepared to buy bonds if it was clear it could not achieve its inflation target, few envisaged such extreme circumstances.
London-based James Aitken of Aitken Advisors says few central banks “had put in as much effort into understanding the plumbing of their own, not to mention the global financial system, as the RBA”.
“No central bank wants to deploy unconventional monetary policy, but the RBA was long prepared for this moment,” says James Aitken of Aitken Advisors.
The Reserve Bank’s bond purchases had a dual purpose.
The first was consistent with quantitative easing measures embarked on by other countries – to expand its balance sheet to buy bonds with the aim of lowering costs to support the economy.
The second was to bail out a broken bond market that had reached a point of dysfunction as sellers overwhelmed buyers while dealers had maxed out on their limits to facilitate trades.
On 11.15am on March 20, the Reserve Bank submitted a notice to bond traders to inform them they would be prepared to buy $5 billion of government bonds – with maturities of two and eight years – in an auction held at 3.25pm.
The process went off without a glitch and anxious dealers offered their bonds to the central bank.
A week later, the Reserve Bank had bought $21 billion of bonds, in daily auctions, including $2 billion of state government bonds.
That sector of the market had come under particular selling pressure, posing a threat to those governments that face a revenue hit from falling payroll and property taxes.
A buyer of any size was a welcome relief.
The central bank’s efforts had helped ease some of the strain in the bond market – mainly in allowing over-burdened dealers to free themselves of bonds so they could once again perform their function of matching buyers with sellers.
And its efforts and intentions had helped to anchor the three-year rate towards 0.25 per cent.
“Under enormous pressure, their communications and guidance have been consistent and concise. Australians should be proud of the ongoing effort of RBA senior management and all their staff,” says Aitken.
But the state of the bond market remains a real worry. While bond markets globally have clogged up, the Australian fixed income community is fearful about the consequences of a prolonged disruption.
Some of Australia’s largest bond funds that have been dealing with a wave of redemptions have upped their exit costs, while there are persistent rumours of blow-out monthly losses.
Again this is something central bankers had seen coming. The Reserve Bank’s Guy Debelle has sounded repeated warnings to bond funds that the market had changed forever.
They needed to accept and prepare that in moments when everyone is rushing for the exit at the same time, they will be forced to pay a high price.
But the fact is they did not – and now the industry is said to be pleading with the Reserve Bank to consider taking a lead from the Federal Reserve and stepping in to purchase corporate bonds, where the market dysfunction is greatest.
‘No matter what people tell you, the role of the RBA is not to bail out investors,” Aitken says.
It’s a tough call that the Reserve Bank is likely to be reluctant to make. With an economic downturn of epic proportions looming, credit traders are stepping aside. The reluctance is not soley because their market isn’t working, but because of doubts these companies can pay their debts and the bonds will be money good.
Of more immediate concern is the state of the government bond market. While the Reserve Bank has begun to tame the short end of the bond market, longer term rates remain unruly.
The 10-year rate had last week fallen below 1 per cent but the Reserve Bank has yet to flatten the yield curve.
The long-term borrowing costs relative to short-term costs are still twice as high as they were before the coronavirus crisis took hold.
While the Reserve Bank’s historic intervention in the bond market has provided cover fire, it is these markets that Rob Nicholl and the AOFM must face as he sets about funding a deficit.
In order to ensure the already unfathomable economic damage from the coronavirus crisis is kept at a minimum, the Morrison government says it will spend billions.
On Monday, it announced a historic $130 billion wage subsidy package.
UBS economists are now forecasting a total federal and state budget deficit budget approaching $300 billion or 16 per cent of GDP, a level not seen since World War II.
Total federal and state government debt would grow by $500 billion.
The bond market is now waiting for the details of how the AOFM will meet its Herculean task, and just how many bonds the Reserve Bank will buy to support the economy and the functioning of the market.
Australia’s history as a nation is told by its bond market.
It has faced crises before and met the challenges in financing wars and recessions.
Few doubt this monumental and historic task can be achieved – the question is at what cost.