Accounting for the inevitable rise in interest rates
Recently, the Reserve Bank of New Zealand caused markets to react after announcing that interest rates could be on the rise sooner than expected. The New Zealand dollar rallied and the bond market sold off. Even across the pond in Australia, the announcement saw markets react. Whilst the RBA has maintained their stance of lower for longer, the RBNZ's forecast is important for investors, particularly those wanting to know how to position themselves for an inevitable rise in interest rates.
In this monthly PIMCO Update from the Trading Floor, we discuss how to avoid market noise when interest rates do eventually rise. We also outline the RBA's toolkit, discussing what term funding facilities mean and the short and long term implications of the banks funding themselves.
David Erdonmez: There has been some noise recently in the media around the path for interest rates to move higher and particularly from the RBNZ perspective. Could you talk about that a little bit and put that into the context of the RBA and what that means for us here in Australia?
Robert Mead: When the RBNZ included in some of its forecasts an indication that rates would be higher prematurely versus what they’d previously mentioned, markets reacted quickly so the New Zealand dollar rallied, bond rates sold off.
Since then there has been a little bit of a stepping away from those forecasts so they’re not really a forecast for where policy rates will be. But it does show that, when it comes to central banks taking their foot off the accelerator, there is going to be a lot of noise. That’s great for us as an active manager because we get to work out what is noise and what is reality.
Since the RBNZ, we’ve had the RBA who were much more measured and made it very clear that they’re waiting for July. They have already told us that they’ll make some more announcements then. More recently they have been very measured and I think they are staying the course, but there is a lot of news to come.
David Erdonmez: So what is actually priced into markets, is it a real change in stance? Are we becoming a bit more hawkish in terms of the outlook for interest rates here?
Robert Mead: The good news is that markets are forward-looking, so they aren’t waiting. And they are also putting in some sort of risk premium around where the rhetoric is coming out from the central banks. So the RBA keeps saying - and they have reiterated very recently - that they don’t expect inflation to sustainably be in the range to allow them to move the policy rate until 2024 at the earliest.
The market’s already got a hike priced in in late 2022, and by the end of 2024 the cash rate is almost 150, in terms of how the market’s pricing. So there is a lot of risk premium already built in, and the markets are really looking forward as much as possible.
David Erdonmez: So let’s turn our attention to another aspect of what we are seeing from the RBA. They’ve got I guess four things in their tool kit at the moment that they are focusing on: a cash rate of 10 basis points; we have yield curve control out to 3 years where they are keeping bond yields at 10 basis points; we have quantitative easing, where they are buying state government and government bonds; but then that fourth piece is around the term funding facility (TFF) and how banks are funding themselves.
I think the key thing here that we are interested in is that that the TFF expires in June, so that’s a two-and-a-bit billion dollar facility, banks can borrow at 10 basis points out to 3 years. So with that rolling off at the end of June, what does that mean for how the banks are going to fund themselves? What does that mean for term deposits, or mortgage rates?
Robert Mead: It is probably as you said: out of all the various tools, and there are many, it is the first one that gets switched off and there is every indication that it ends at the end of June.
There is about $75 billion still left available and we expect that at least some of that will be tapped over the next few weeks. But the most important thing is that I don’t think there is a complete repricing of markets. Maybe fixed-rate mortgages go up a little, because they have been obviously very low, so as you take out some of that cheap bank funding the ability for them to offer that on to the consumer, to the borrower, is more limited.
The other thing is that we saw just last week that one of the majors was able to issue over three and a half billion dollars of 5-year and 10-year securities at close to record-low credit spreads. So we don’t think any compete repricing of the market’s coming. We look forward to some of that change though in the sense that less financing, less funding from the central bank means probably more RMBS. So that is a sector we actually strongly prefer versus unsecured bank funding. So again looking into the second half of this year we should see a little bit more balance in terms of the supply.
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Robert co-oversees the portfolio management teams in Asia. Previously, he was a portfolio manager in Munich and head of the European investment grade corporate bond team. He has 29 years of investment experience.