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Interest Rate Outlook – February 2015

Stamford Capital

Interest Rate Outlook – February 2015

Stamford Capital is pleased to provide a commentary on the interest rate outlook from our strategic partner, Russell Maisner, principal of Global Treasury Risk Management Pty Ltd.

The move by the Reserve Bank of Australia (RBA) last week was largely unexpected by most RBA watchers and forecasters. We too, only gave the percentage probability of an interest rate cut at this time a 30% weighting………until the Terry McCrann article appeared on the 28th of January. The market at this point, increased probability weighting to in excess of 90% based upon the interbank futures market and the swap rates. Clearly the swap traders were correct on this occasion.

McCrann has had a canny knack of seeming to feel when the RBA is about to adjust policy in any direction and his insight has again proved to be accurate.

2015 is shaping as year when interest rates are lower and the lowest level in most of our lifetimes. However, when compared to the rest of the world, Australian interest rates are still high – barring developing countries of course. The greatest surprise to us has been the shift in language which the RBA has adopted in its monetary policy statement.

Research of past policy statements and commentary of Glenn Stevens, demonstrates that he consistently advocates stability and appropriateness of policy. The governor has been usually quite hawkish in his previous comments over many years, but on this occasion, the commentary shifted – which it has previously done when policy has changed.

The interesting questions are why? Some analysis and reasoning around this is likely to include:

  • Low inflation outcomes and forecasts- RBA likely to forecast 2.25% but could be as low as 2.00%
  • Higher domestic unemployment pressures and forecasts (as demonstrated by today’s unemployment numbers)
  • Lower domestic growth than forecast into 2015 and sluggish growth into 2016
  • Global GDP concerns
  • Higher risk of recession and low growth in Europe
  • Lower oil prices
  • Disinflation
  • The US seems to be on a different sync with growth

It is also worth noting that patterns across assets and rates have shifted. Those active in property markets have seen shifts in investor appetite, bank funding, other sources of funding, valuations and difficulty in securing assets at acceptable hurdle returns. It could be argued that part of this paradigm shift in all commercial valuations is based upon offshore interest in Australian real estate. With a currency that has declined by around 23%, A$ assets appear all the more attractive.

We have stated in previous outlooks that inflation is not to be feared as it is usually a partner for economic growth. Whilst low inflation and growth can co-exist, combined with an uncertain global outlook, the RBA has followed the lead of the interest rate futures market with a downward adjustment in the cash rate.

As markets like to think of interest adjustments as not singularly applicable, it has taken to price in further cash rate reductions. The attachment following is a snapshot of the future expectations of the cash rate at each month. Based upon the settlement price, the market is forecasting a cash rate of 1.88% by September this year. It weights this at around 119% probability at this stage.

In effect, pricing is implying a cash rate of 1.75%, which is two further interest rate cuts based upon 25bpts at each cut. All of which is possible.

Cash Rate

 

 

 

 

Markets pricing future downward movements in cash rates (Source –Thomson Reuters)

Moving on from the history lesson to the future and potential implications.

The dilemma or lack of facing borrowers with large debt exposures is what to do next. It would be reasonable to suggest that most borrowers are feeling pretty comfortable with lower variable interest rates and perhaps at a discretionary level, do not need to hedge any debt to a fixed rate. This view is reasonable in the current climate with perhaps the forecast of further rate reductions. One view that should be quite strong however, is the likelihood of any interest rate increase this year and into early 2016 seems very remote.

As many borrowers are aware, lenders can request borrowers to hedge a portion of their debt exposure. With this in mind, we have been searching for the ‘value trades’ that can assist borrowers to be compliant within lending covenants.  The following (Attachment 2) demonstrates the differential on a current and historical basis between a two year (quarterly swap) and one month BBSW. It is quite easy to identify that the fixed rate is leading the floating index lower. This has occurred on a few occasions in the past three years, but never at these unprecedented nominal levels.

If we use an example of a construction facility which usually has monthly drawdowns and BBSY as a floating rate index, the difference between the fixed and floating rate is even greater; ie 2 year swap @ 2.13% and 1 mth BBSY (5 bpts higher than BBSW) 2.41%. Therefore the cost of carry based upon mid market pricing is positive in favour of the borrower today. What isn’t known and a key to the future cost of carry is whether there will be further interest rate reductions and whether or not the fixed rates of today trend lower. The one guarantee that can be made is that neither of the benchmarks remain static and will change over time.

Whilst not trying to confuse anyone, the correlation between the two benchmarks can be an inexact science. Hedging is around taking risk in a transaction away from that transaction. Globally, Australia still has a high interest structure.

There are other possible hedging strategies that can work in a decreasing interest rate environment which we would be happy to discuss. Each of these strategies can be tailored to suit requirements of the borrowers.

BBSW

 

 

 

 

Differential between 2 year quarterly swap and 1 month BBSW (Source – Thomson Reuters)

The central bank seems committed to foster growth domestically and appears to have taken a global view in determining its current action. It could further be assumed, that there may be further downward adjustments to monetary policy based upon commentary analysis. Currently, there is no known ‘event’ so it would be reasonable to suggest that the next move will not occur in March as past behaviours by the RBA have demonstrated an adjustment, followed by a period of no change.

With the changing landscape of property funding and interest rate risk management, Stamford Capital and Global Treasury would be pleased to assist with any further requirements.

Source:  Stamford Capital Australia Pty Ltd
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