Why Australian Funding Costs Are Elevated Under A Stable Cash Rate

  • Demand and Scarcity Combined Unleash Powerful Forces
  • Traditional Low Cost Funding Sources Are More Challenging
  • Banks Restructure Liabilities to Optimise Bank Liability Tax
  • Multiplier Slows as Broad Money Free-falls

One key factor of profitable banking is to lend long and borrow short with adequate control of pricing margins. However, replenishing the supply of liabilities is a much more important element. A liquidity squeeze within the overall market is an environmental hazard to avoid.

The rapid rise in short-term interest rate benchmarks and the aggressive change in the shape of the yield curve since mid-February is cause for heightened awareness. There have been numerous discussion papers on recent observations and causal factors with many claiming it is a passing phase, but others believe we have transitioned to this point via a confluence of more structural changes than cyclical ones.

The new BBSW methodology is a revised modus operandi, which the market is adapting to. Have we structurally changed the way short-term funding works?

For money market dealers many carry trades or arbitrage trades are now uneconomic due to both market pricing and regulatory imposts. The new bank liabilities tax has materially shifted the willingness of the major banks to economically supply liquidity. To this end, NCD issuance has reduced by $22 billion or 12.5% in the last 12 months. Whilst the NCD market has traditionally been a source of cheap funding for ADIs, the assumed responsibility of the issuer to provide T+0 liquidity support does not sit comfortably within an LCR and NSFR framework. The steady decline in NCD issuance by all the major banks is a trend to watch.

This diminished supply of negotiable securities with minimal interest rate risk is a form of rationed liquidity, which manifests our own Quantitative Tightening. Over the last 18 months the Reserve Bank has stepped forward to provide $30 billion of net new funds to the market via Reverse Repos. At increasingly wider yields to the official cash rate, these higher funding costs make many carry trades in assets such as ACGBs out to 3 years uneconomic or marginal. Could these structural changes be influencing the rapid fall in broad money over the last 9 months to just 2.6% whilst credit growth continues to be more stable at 5.0% growth?

The velocity of arbitrage trading opportunities is constrained. Higher funding costs have breached asset yields and offer only negative earnings. Inverted yield curves offer the same characteristic of negative returns unless capital gain in the leveraged asset is assured. Australia has not only developed the sound economic performance over multiple decades that warrant us being viewed as the “Switzerland of Asia”, but we are fast developing a yield curve commensurate with the status of being seen as the “Bunds of Asia”.

On 20/6/18 BBSW 6mths rose above the 3 Yr Swap rate by 5 bpts, 2.25% vs 2.20%. Will we see the more important BBSW 3mth rate currently at 2.12% rise the remaining 8 bpts before this inverts as well? The favoured receive carry trade for swaps out to 3 years will then be viewed as uneconomic, lacking essential positive carry. A pay fixed / receive floating psychological bias may then vie for mainstream thinking simply by offering positive carry. It is an imperative to accurately forecast the demand dynamics of the BBSW curve out to 6 months relative to the path and timing of Global and Australian cash rates if you are intending to predict the ongoing influence of the interest rate swap market.

This week Australia has taken another key step toward developing a more sophisticated home and investor mortgage refinancing market on the back of our emerging low, flat, medium term yield curve. AMP announced on 19/06/18 a fixed rate loan offer of 3.79% for owner occupied borrowers with <=90% LVR. This is extraordinary, being only 20 bpts higher than Bank of Sydney’s 3.59% variable rate loan and 11 bpts over a swathe of lenders at 3.68% like Gateway Bank and CUA. I expect the recent strong demand for new liabilities by these ADIs will influence mainstream term deposit pricing well into the new financial year.

Australian mortgage borrowers are developing a real appetite to substitute their lenders at a cheaper cost. Major Bank Treasurers are likewise undertaking a similar substitution strategy looking for a better deal on their borrowings. They are progressively responding to the new US Corporate Tax policy by adjusting their foreign / domestic funding mix to immunise themselves against a diminishing pool of offshore depositors and a higher interest rate profile in Libor based funding markets.

The clear indication of a domestic funding resurgence is the reconfiguring of the positive slope of the term deposit curve we had during the last few years of fine-tuning LCR and NSFR ratios. Terming out liabilities was encouraged via low short-term rates and far more attractive long-term rates. A steep differential was the bait. Today we have quite the opposite evolving. High yield, flat curves are the new norm as they encourage all investment profiles equally. High rates for 3 months, which are either above or below long rates by 5-10 bpts are one of the main discussions points in our client conversations. Both investors and borrowers are winning at present. Term deposit yields are more lucrative, coupon resets on floating rate products like FRNs are improving for investors and term borrowings are pricing off a low, flat swap curve that shows no inclination to reinstate any term risk premium. Our clients seem to be winners all round.

The presence of the major banks in the 2 – 6 month funding sector is materially changing price dynamics of low cost funding, which has been the province of smaller ADIs. At present, it seems supply of funding for the larger banks is far more crucial than finessing net interest margin. Guaranteeing sustainable supply is the clear and present danger and challenge to all ADIs.

The dynamics of scarcity and reduced liquidity are becoming more evident in many quarters. The speech by Rob Nicholl CEO of AOFM at the ABE luncheon on 29 May 2018 warrants a re-read to understand the structural change they are proposing to their modus operandi and its impact on cash markets. Guy De Belle’s speechfrom mid March can also be viewed as a signaling statement that key risks may not be priced correctly if much tighter global financial conditions are looming.

Asset growth has to slow if liability growth is slowing. Credit rationing is already apparent. It is being commentated as a key reason in a weakening housing market. The major banks are being more discerning on client segment, loan size, location demographics and equity contributions by borrowers. Hence, borrowers are willing to explore new channels of supply. A fringe credit spectrum evolving through Fintech channels is the genesis of a private equity based shadow banking system too. Credit rationing will certainly be a catalyst for growth in this sphere.

The infant ” .V ” shaped yield curve with the dot being the low official cash rate, lofty short-term rates, lower rates from 1 – 3 years and then positive shape beyond begs the following question. If funding benchmarks such as the BBSW 1, 2 & 3 month rates (2.00%, 2.07% & 2.11%) diverge too far away from the RBA OCR (currently at 1.50%) and sustain those higher levels, then which of the following scenarios is most probable:

1. Monetary Policy remains unchanged until more compelling data emerges; or

2. Monetary Policy is tightened to endorse the higher wholesale market price; or

3. Monetary Policy is eased to alleviate the elevated wholesale market price.

Where does the highest level of financial stability lie?