–  OCTOBER 2021 INSIGHTS BY THE CURVE TEAM –

Summary

RBA Recap

  • Following the RBA’s call to monitor lending standards, APRA implemented a key change regarding loan serviceability buffers.
  • The Minutes for September highlighted the differing factors driving the RBA’s decision on QE as opposed to the cash rate.

Markets Recap

  • There was a considerable pick-up in yields across a range of assets as markets grappled with persistent inflation and imminent central bank tightening.
  • It led to bonds trading at discounts and higher rates for longer tenors.

Investing Considerations

  • Bonds trading at a discount pose an opportunity for investors, but also a dilemma.
  • Longer tenors look increasingly attractive.

Australian Economy

  • With lockdowns in NSW and Victoria, the economy remains at two different speeds.

RBA Recap

Policy Decision:

There was no change in the RBA’s current monetary policy stance in October, with QE to proceed as announced last month and no change to the cash rate or April 2024 yield target. The key aspect of the decision was the allusion to macro-prudential targets on lending. The RBA said “it is important that lending standards are maintained and that loan serviceability buffers are appropriate”.

The following day, APRA acted on the loan serviceability buffers. Instead of assessing the ability of borrowers to repay when loan rates are 2.5% points higher than the current rate, a 3% buffer will need to be used. Reducing leverage and maintaining financial stability were the motivators.

This could foreshadow more changes. Loans to investors have been picking up relative to owner-occupiers, as overall wealth (including house prices) has drastically increased. Regulators will want to avoid a self-fulfilling cycle, where higher house prices enable more loans, which further fuels prices. Loans with high debt to income ratios and curbing investor activity will likely be the next reforms in the regulator’s sights.

The increased loan assessment buffer also gives credence to higher interest rates. As markets price in continuous and gradual cash rate rises from late next year, it is plausible that over the duration of a home loan rates will rise to higher levels than when the loan was initiated.

September Minutes:

The factors determining a change to QE and the cash rate are different. Tapering QE purchases to $4 billion a week until February was influenced by other central banks. The RBA referenced “the fact that other central banks are tapering their bond purchases” and that “the Bank’s bond purchase program is expanding faster relative to the stock of bonds outstanding than that of many other central banks”.

A key transmission effect of QE is the exchange rate. Other central banks tapering QE puts downward pressure on the Australian Dollar. When QE was implemented, the RBA was weary of the Australian Dollar being artificially high due to overseas QE programs. Should they cease or be tapered, there is less need for the RBA to continue.

Also, the RBA noted that “the economy is expected to return to its pre-delta path by mid 2022” as a justification for QE. This implies forecasts are still relevant when deciding on QE.

By contrast, the cash rate will be determined by actual inflation outcomes, not forecasts. While the decisions of other central banks will be considered, they will not be considered as explicitly when deciding whether to increase the cash rate. Wages and inflation remain the key factors for a cash rate increase.

It is worth differentiating these different motivators. Otherwise investors risk conflating QE tapering and cash rate rises.

Markets Recap

Yields Increase

Benchmark rates have increased. Notably:

  • Last month, the 1 year, 3 year and 5 year swap rates were around 0.06%, 0.44% and 0.80% respectively.  They are now 0.15%, 0.70% and 1.20% respectively.
  • US 10 year Treasuries are now above 1.60% whereas last month it was hovering above 1.30%.

A range of factors have pushed rates higher. Two interrelated factors are high inflation led by supply chain disruptions and expectations of central bank tightening.

The world is grappling with supply chain issues, ranging from shipping price increases, a lack of energy supply and restricted access to overseas labour. As a result, higher prices are proving more persistent, which risks changing expectations of businesses and consumers to anticipate higher prices, which would prompt central bank action to avoid a spiral of higher prices. Already overseas, there is evidence of wage growth and businesses passing on higher prices. This is yet to play out in Australia.

With this outlook, markets anticipate central bank tightening. The Fed has gradually brought forward its expectation of cash rate rises to align more closely with market expectations. Currently, a rate increase is expected either late 2022 or in 2023. QE tapering in the US is expected late this year. As a result, benchmark yields such as swap rates and government bond yields have been rising.

It has led to yields in a range of other assets increasing. Some examples include:

  • Both NAB and United Overseas Bank’s recent primary 5-year issues have been trading at a discount. NAB issued at +41 and United Overseas Bank at +40. These are now trading at yield to maturities higher than their issue margin, equating to a capital price below 100 to purchase the bonds.
  • 3-5 year term deposit rates have increase 15-20 basis points. Rates are as high as 1.50% for 5 years, 1.15% for 4 years and 0.90% for major banks. For BBB rated ADIs rates are even higher.
  • CBA fixed bonds with 3 years to mature trading around 0.85% for 3 years. This is in line with major bank term deposit rates but would be a liquid investment.
  • A WATC (Western Australian Treasury Corp semi-government body) fixed bond with 5 years to mature, now trading at around 1%. It was trading closer to 0.80% a month ago.

At shorter tenors, increases have been much more muted.

NCD Issuance Up

Despite the lower rates at the short end of the curve, more ADIs were willing to issue NCDs over the past month (which is relevant to financial institutions). NCD issuance for August decreased by $4.6 billion, or 2.2% according to APRA. But if the previous month is anything to go by, this may tick back up over September and October.

Up to eight domestic ADIs were willing to take NCDs, where for the past year issuance has been extremely restricted, especially from the domestic ADIs. +10 for 3 months was the standard rate and longer tenor rates depended on the ADI. Rates as high as +20 for 6 months and +25 for 12 months were available. Foreign branches still have the highest short term NCD rates.

Judo Credit Rating

Judo Bank received a credit rating of A-3 short term and BBB- long term with a positive outlook by S&P. It meant a range of investors who are unable to invest in unrated ADIs could invest in Judo. Their term deposit rates post rating were very attractive, with particular interest for 1, 2 and 3 year terms, which had rates of 0.65%, 0.95% and 1.20% respectively. These have since fallen but remain above market.

While Judo are still growing strongly, their appetite for funds should remain strong, therefore their rates should be attractive relative to market. They have already indicated they are happy to continue taking new funds over October but will not have unlimited appetite.  As Judo matures and/or if their credit rating improves, their rates will fall closer in line with market rates. This means there is an opportunity to invest at higher rates now rather than waiting for their rates to normalise.

Investment Considerations

Longer Tenors

Current factors, such as inflation and central bank tightening is being factored into longer term rates. The cash rate is not just expected to rise to combat current inflation, but is expected to continue to rise, to be over 1% by 2025. As such, the 5-year swap rate is higher than September 2019, when the cash rate was 0.75%.

This seems to be extrapolating the current experience of high inflation and central bank tightening too far into the future. A cash rate of over 1% even by 2025 would buck the trend of the developed world struggling to raise rates since the GFC. It would also require central banks to either have a more hawkish bent or for the economy to not be materially impacted by higher rates. The latter is hard to imagine, given loans advanced under the current low interest rate environment will come under more stress in a higher interest rate environment.

Therefore, longer tenors, i.e., three years and longer should be considered given the recent rise in yields. February is a recent example, where yields increased drastically. Many investors believed yields had further to run so avoided investing. Instead, they flat lined or declined. Only now have longer term yields exceeded the February levels.

Similarly, with Fed tapering imminent and cash rates expected to continue to rise over next year across the developed world, many investors are expecting rates to increase further. This may well happen. But current rates have climbed considerably and should there be any hiccup with the economy as central banks tighten or inflation falters, then current rates will seem appealing in hindsight.

Therefore, we encourage investors to consider putting at least part of their portfolio into longer tenors, especially those that have a disproportionate amount in cash.

Secondary Market Bonds at a Discount

Last month we discussed how the return of primary issues in a rising interest rate environment posed an opportunity and dilemma for investors. It was an opportunity, in that new bond issues have been few and far between. The dilemma was whether to take the primary issues as they come, or wait for future primary issues that potentially have higher rates.

The emergence of bonds trading at a discount poses a similar dilemma. Should investors buy primary issues or wait for them to come on the secondary market when trading at a discount?

The strategies of dollar cost averaging and averaging in discussed last month are just as applicable to bonds trading at a discount. There is no guarantee interest rates will continue to rise indefinitely. And even if they do, there may be periods where they remain flat. If investors choose not to invest in primaries in the hope they will become available in the secondary market, then they will be sitting on the sidelines forgoing higher yields while they wait for bonds to be available at a discount.

By having set rules and amounts you plan to invest (according to dollar cost averaging and averaging in), your portfolio will be positioned to gain from any interest rate scenario. For example, if you want $5 million allocated to a certain new issue but suspect it will be at a discount in a few months, you may invest $2.5 million in the primary and $2.5 million when it becomes available as a discount. If it never becomes available at a discount, then you still have invested $2.5 million. If it becomes available at a steep discount, you have $2.5 million left to invest at a very attractive rate.

Australian Economy

The Australian economy is traveling at two speeds. Continued lockdowns in the South East of the country continues to dominate the data. While the other states remain open and their economies are going about their business, the impact of lockdowns is having a disproportionate effect.

Employment and spending data is where this impact is clearest to see. Total employment has been hit hard at the aggregate level. A similar impact can be seen when it comes to consumer spending. Drilling deeper into the data shows a clear impact from lockdowns. This is one of the big reasons that the RBA has made it clear that no major decisions on monetary policy will be made until the first meeting of 2022 in February.

With NSW entering the first phase of opening up this week and the next phase expected to follow imminently, the national economy will start to embark on a massive transition towards living with Covid-19. This transition is expected to be slow at the national level as the states and territories move at different speeds. The states that are covid free are likely to be more cautious in fully reopening which will delay the economy getting back to what will be considered the new normal.

By mid next year we should start to the see the economy back at its pre-delta trajectory. That is one of the major reasons the RBA continues to provide a significant amount of support to the economy.

Joshua Stewart

Associate - Money Market