Australian Reserve Bank Warns of ‘Sharp Correction’ in Financial Markets

A man looks at an electronic board displaying stock information at the Australian Securities Exchange, operated by ASX Ltd. in Sydney, Australia, on March 16, 2020. Brendon Thorne/Getty Images

The current historically low-interest rate has increased the risk of a looming “sharp correction,” the Reserve Bank of Australia (RBA) warned.

In her keynote address, Marion Kohler, the head of the domestic markets department at the RBA, told the Australian Securitisation Forum that the central bank was keeping an eye on security markets.

“One area of focus stems from the current historically very low-interest rates,” Kohler said. “Asset prices increase when risk-free rates are low, and this is part of the monetary transmission mechanism.”

However, this also led to increased “search for yield” behaviour, where investors, in a low-interest environment, will consider putting riskier assets into their investment portfolios.

“Investors bid up the price of risky assets to the extent that risk may no longer be adequately priced,” Kohler said. “This, in turn, increases the risk of a sharp correction down the road.”

Kohler noted that during the Global Financial Crisis (GFC), volatility in equity prices and risk premiums for bonds and equities remained elevated.

“[But] every crisis is different, so that means you really need to set out with flexibility and tailor the tools for the challenges at hand,” she said. “This time around, the challenge was really the very low-interest rate at the outset of the pandemic.”

A woman walked past the Reserve Bank of Australia sign in Sydney on October 4, 2016. WILLIAM WEST/AFP via Getty Images

Australia’s cash rate at the start of COVID-19 was 0.75 percent, which was swiftly lowered to 0.5 percent in March 2020 before dropping to 0.1 percent in November 2020, where it has since remained.

In contrast, Australia’s cash rate during the second half of 2007, when the Global Financial Crisis (GFC) began, actually started increasing to a peak of 7.25 percent before dropping to 3 percent in 2009.

She said the economic concerns of COVID-19 led to rising uncertainty caused a short but sharp adjustment in securities prices.

“The period of volatility was brief,” Kohler said. “Risk premiums have increased in the initial phase by much less than during the global financial crisis, and were elevated for a shorter period.”

AMP Capital’s chief economist Shane Oliver said the increased money supply and excess household savings currently seen is radically different to the post-GFC period.

“The pool of excess saving provides a boost to spending and a potential disincentive to work (until it runs out) and with increased money supply risks an ongoing boost to inflation, beyond the pandemic driven boost currently being seen,” Oliver said.

He pointed to high inflation as the most significant economic risk of COVID-19 in the long-term, as the monetary and fiscal response to the pandemic has likely broken the previous disinflationary period, similar to the expansionary policies after World War II.

“This, in turn, means the tailwind of falling inflation and interest rates which provided a positive reflation and revaluation boost to growth assets is likely behind us,” Oliver said.