Spotlight on Australia’s interest rates

As was widely expected, the Reserve Bank of Australia (RBA) declined again to change its cash rate at its most recent meeting1. Indeed, their post-meeting commentary has further dampened expectations of a rise in rates this year. Market pricing of the likely amount and timing of future rate hikes is now better aligned with our view that there is unlikely to be any move in the RBA’s policy rate until well into 2019. There are however, some market moves in Australian interest rates that are, to an extent, beyond the RBA’s direct control and worth watching – especially as consumers and investors.

Australia is not a master of its own economic destiny

Recent market moves illustrate one of our fundamental beliefs that as an open and relatively small economy, Australia is not the master of its own destiny. The main move has been an increase in the interbank lending rate – the Bank Bill Swap Rate (BBSW).

By way of definition, ‘interbank’ refers to the rate at which banks lend and borrow between themselves to manage liquidity and their reserve requirements. The reference rate for interbank lending in Australia is the BBSW – the benchmark used to price interbank loans and many business loans. A business will often have its interest rate priced as a margin above the BBSW, for example the three-month BBSW + 100 basis points (bps), meaning the cost of its debt repayments is directly influenced by movements in the BBSW. As the three-month BBSW at the time of writing equates to a rate of 2.065 per cent, the additional 1.00 per cent would equal 3.065 per cent.

The rise of the BBSW will likely squeeze the fortunes of mortgagees and borrowers

For the last 18 months, the BBSW has been reasonably stable at around 20 bps over the RBA cash rate. Recently, however, it has jumped to around 50 bps above the cash rate. Local banks borrow something in the order of 40 per cent of their total funding requirement in this short-term market. This has had the effect of increasing borrowing costs for banks and businesses, despite no move in official rates.

Those cost increases may find their way into the economy through higher borrowing costs for bank customers (most likely), lower deposit rates (possible), or lower returns to shareholders (less likely). Indeed, Suncorp, Credit Union Australia and ME Bank have already raised the rates they offer on several of their mortgage products.

Accordingly, we are already experiencing a tightening of monetary conditions

This is despite an RBA stance of “no change” and their relatively flat commentary on our economic outlook. How has this happened? There are several causes; however, what is also interesting is the mechanism of transmission (i.e. US dollar liquidity) both onshore and offshore in the US.

Firstly, the Trump “amnesty” to large US corporations with offshore earnings has allowed those companies to bring the US dollars they held in jurisdictions outside the US back home to be used for reducing local borrowings, undertaking share buybacks, and funding investment and wage increases.  This has had the effect of removing those dollars as a source of funding for Australian and other international companies, forcing them to source funding from within their home markets, which has in turn pushed up domestic borrowing rates.

Secondly, it is also likely that the US government’s increased borrowing requirements (as it runs an ever-increasing fiscal deficit) has emphasised this crowding out, as has the Federal Reserve, by initiating the unwinding of its quantitative easing program.

It is not yet clear how long this increase in the BBSW is likely to last, but our view is that it’s likely to persist

This is especially so while US rates continue to move upwards and Australian rates remain static. On a positive note, for Australian investors there have been several higher quarterly hybrid interest rates
set based on that elevated three-month BBSW (for example, NAB Capital, Westpac Capital and ANZ Capital).

Less positive however, as explained earlier, is the rise in business and mortgage borrowing costs.  A number of economic commentators have questioned the banks’ ability to pass on those increased costs to mortgage holders, especially under the gaze of Australia’s Banking Royal Commission. More cynical observers point to the alignment of CEO’s interests with those of their shareholders, rather than their borrowers. Suffice to say, banks are again being squeezed – this time by international forces – and as a whole, the Australian economy will likely feel the drag.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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