Commodities rally putting pressure on RBA

From InvestorDaily.

A commodity-driven spike in Australia’s nominal GDP is putting the Reserve Bank of Australia under increased pressure to hike interest rates, says Nikko Asset Management.

Australia has seen strong growth in nominal GDP in the past year, thanks largely to the strong rally in commodities prices, according to Nikko Asset management fixed income portfolio manager Chris Rands.

The commodities rally is likely to continue for the next two quarters, Mr Rands said – but whether it continues longer than that will be down to Chinese demand.

Either way, the bright outlook for Australian economy over the next two quarters could potentially give rise to a more hawkish RBA than the market expects, he said.

Few economists are expecting the RBA to hike interest interest rates in the near future given the bank’s fears about further stoking domestic house prices.

But the sharp divergence between nominal GDP and the official cash rate (which have traditionally moved in lockstep) suggests it will be weighing on the RBA’s mind.

“In a strong nominal GDP environment, the RBA is typically either hiking rates or keeping them on hold,” said Mr Rands.

“Over the past five years, the cash rate has been moving in only one direction, and this new information could see the RBA taking a more hawkish tone than what the market is expecting,” he said.

The question for investors (and the RBA) is whether the rally in commodities that is driving nominal GDP growth is sustainable, Mr Rands said.

“If the commodity sector has been driven by Chinese fiscal expansion, this momentum could begin to run out during the second half of this year,” he said.

What interest rates will mean for your mortgage choices

From The Conversation.

For many of us, our home is the single most important investment we will make in our lifetime and mortgage payments can take up a huge chunk of our income. As politics and economics seem to deliver nothing but uncertainty, how should home owners or first-time buyers react?

Things still look tight for household budgets. One recent survey showed that the average mortgage payment for a three bedroom house in the UK is about £965 per month, more than half the average take-home wage.

That is with interest rates at historic lows. And they are staying put. The nine members of the Bank of England’s Monetary Policy Committee have decided to keep the official interest rate in the UK, the Base Rate, at that ultra low level of 0.25%.

The fortified walls of the Bank of England on Threadneedle Street. Robert King/Flickr, CC BY

In various guises, this rate has been around since 1694. It is the rate at which high-street banks borrow from the central bank and its function in the economy is simple but effective. If banks can borrow money cheaply from the Bank of England then they tend to pass it on cheaply to us, the public. When their borrowing gets expensive, so does ours.

The Base Rate is only an overnight interest rate but it starts a domino effect with more long-term interest rates. If it is raised then the whole economy is soon paying more to borrow money.

But if that’s not happening now, what about when the MPC meets again on March 16?

Up, up and away

Let’s start with the bad news for those paying a mortgage or seeking one. Interest rates, and consequently our payments, will definitely increase in the future. The graph below shows the history of the Base Rate since 1970. With a historical average of more than 6% and years when the Base Rate stayed consistently over 12% to combat the spiralling inflation of the time, it becomes evident that a rate of 0.25% is abnormally low.

Bank of England, Author provided

The good news for home owners and house hunters is that interest rates could well stay low for a few more years. And all the signs are that when rates do rise, it will be in small increments of 0.25% or 0.50% every few months. A key aim of the Bank of England is not to surprise markets and to be as predictable as possible, particularly at a time when stability and certainty are rare commodities.

Most people will remember why we ended up with such low rates. In the response to the global financial crisis of 2008, central banks sought to make it cheaper for people to borrow money. A low interest rate makes it easier for consumers to afford not just mortgages but also cars, appliances or nights at the pub. Companies profit from our spending and get access to cheap money that helps them expand or stay afloat.

Debt as a driver. Thomas Hawk/Flickr, CC BY-NC

So, if they are so good for the economy, why do interest rates have to go up again? Mainstream economic theory views very low interest rates as harmful in the longer-term. They are a disincentive to healthy saving rates and when the economy is at full-throttle, they act as a boost to inflation which in turn erodes people’s real incomes. They also distort investment decisions and, particularly dangerously for the UK, add fuel to investment bubbles.

Market forces

Brexit and the rise of Donald Trump in the US, the two great causes of uncertainty these days, will probably save us some money, at least in the short to medium term. Brexit brings with it the prospect that businesses will lose full access to an EU market of 450m affluent Europeans. In a climate like this, it would be a foolhardy Bank of England which chose to make money more expensive in the UK.

Trump, meanwhile, is known to favour a cheap dollar and low interest rates in the US in an effort to make exports more competitive. The Bank of England, as ever, will keep a close eye on its US counterpart, and will likely avoid increasing UK interest rates for fear of pushing the pound higher and blocking out much needed investment from the US.

So how can you use this information?

First of all, I’d avoid taking a mortgage or any loan that I could only barely afford as rates will eventually rise. For those that already have a mortgage, most commentary on the real-estate market will advocate for a fixed-term mortgage but that is not necessarily a good idea. The most popular fixed-term products offered by high street banks are usually for a period of two years.

The trouble here is that you will normally pay a fee and a higher interest rate as the cost for fixing, during which time rates are unlikely to rise anyway. And so only fixed mortgages of five years or more start making sense – and you would still pay fees and a relatively higher interest rate for a couple of years before you started to benefit.

A good idea would be to make small but regular overpayments into your mortgage, and request that these payments are used to reduce your monthly instalments (rather than to bring closer the year that the loan will be repaid in full). So when the interest rate does increase in the future, the outstanding amount it will apply to will be reduced. Flexible mortgages typically accept unlimited overpayments and even the fixed deals usually allow overpayments of up to 10% each year.

Banks are not particularly happy with the overpayment approach. It reduces their profits and de-stabilises their portfolio a little. But reluctant banks are usually a sign that this might just be a good deal for you.

Are Small Business Bearing Some Of The Bank’s Interest Rate Risk?

An interesting working paper from the IMF was released today. Why Do Bank-Dependent Firms Bear Interest-Rate Risk? looks at the link between bank funding, floating rates and how this is transmitted to firms who borrow on variable rate terms. The paper concludes that banks do indeed transfer interest rate risks to firms, and this is especially so when banking regulation tightens.

Here is the summary:

I document that floating-rate loans from banks (particularly important for bank-dependent firms) drive most variation in firms’ exposure to interest rates. I argue that banks lend to firms at floating rates because they themselves have floating-rate liabilities, supporting this with three key findings. Banks with more floating-rate liabilities, first, make more floating-rate loans, second, hold more floating-rate securities, and third, quote lower prices for floating-rate loans. My results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. They also highlight a role for banks in the balance-sheet channel of monetary policy.

Here is the full conclusion from the report:

Bank lending is in large part funded with floating-rate deposits. As hedging is costly, banks avoid mismatch with the interest-rate exposure of their liabilities, in part, by making floating-rate loans to firms. To establish this link between the structure of bank liabilities and the floating-rate nature of bank lending, I examine the cross section of banks. Banks with greater interest rate pass-through on their deposits hold more floating-rate assets: both loans and securities. In the cross section, these floating fractions are positively correlated with each other. I show that if banks were responding to demand for floating-rate debt from firms instead of their own liabilities, this correlation would be negative.

Moreover, while banks with more deposit pass-through hold more floating-rate loans, they quote lower interest rates for ARMs relative to FRMs. The combination of higher quantities and lower prices points to variation in supply rather than demand. I also present time series and historical evidence supporting the supply-driven view of floating-rate bank lending to firms.

This paper therefore highlights an important consequence of banks’ short-term funding: the potential for interest-rate mismatch. While standard models do analyze maturity mismatch created by short-term funding, they typically do not consider uncertainty in interest rates and interest-rate mismatch.

This paper shows that the structure of banks’ funding has important implications for the choices banks make about interest-rate risk on the asset side of their balance sheets. More broadly, my results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. My results suggest that tighter regulation of banks’ exposure to interest rates might lead banks to pass on more risk to firms, which is particularly relevant given renewed regulatory focus on banks’ exposure to rates.

Bank-dependent firms, i.e. poorly rated firms and smaller firms, are more exposed to interest rates than firms with better access to capital markets. While these firms do use interest-rate derivatives to hedge this exposure, they do so only partially. I show that this exposure is a component of the Bernanke & Gertler (1995) balance-sheet channel of transmission of monetary policy. Banks therefore play a role in the transmission of monetary policy to firms beyond the usual bank lending channel; here the effect is based on existing rather than new bank lending.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Another Perspective On Rate Sensitivity

Yesterday we took a deep dive looking at how sensitive borrowing households are to a prospective rise in their owner occupied mortgage rates. A fundamental, though valid assumption we made was to look at the relative number of households impacted. This distribution led the analysis.

However, we can look at the data through a lens of relative mortgage value, not household count. This changes the perspective somewhat and today we explore this additional dimension.

We use the same movement in rate scenarios, from under 0.5% up, to more than 7% and show the relative portfolio distribution by value of outstanding loans and the tipping point where the household would fall into mortgage stress.

Using this lens, we immediately see that from a value perspective, a significant proportion of value resides in NSW (larger home prices, bigger loans). Within the NSW portfolio, more than 20% of the value would be impacted by a small incremental rise in mortgage rates. We also see some value impacted in VIC and WA, but to a lessor degree. In other words, the more highly leveraged state of households in NSW means a small rise in real mortgage rates will bite hard here. This despite all the focus in the press on WA and QLD!

Another interesting view is created by using our geographic zoning definitions, radiating from the central business district (CBD) in the middle, in concentric rings, out to the suburbs, and into the regions beyond. The areas where sensitivity is highest to small rate rises are the inner and outer suburbs, plus the urban fringe. This is because mortgages are quite large, relative to incomes. In other words, there is a geographic concentration risk which needs to be taken into account.

Our household segmentation models highlights that from a value perspective, young affluent and exclusive professionals have a dis-proportionally large share of value, and a significant proportion of this would be at risk from even a small rise.

Finally, again using our value lens, we can see that the largest segment which would be impacted by a 0.5% or less rate rise are soloists (see our earlier post for definitions) who got their mortgage via mortgage brokers. In comparison, delegators who get their loans direct from the bank, without an intermediary, are least exposed.

So, we conclude it is essential to look at the mortgage portfolio both from a value AND count perspective. But in fact, it is the value related lens which provides the best view of relative risk. This is how risk capital should be allocated.

Larger loans, via brokers are inherently more risky in a rising rate environment.

Are Interest Rates Stuck At Historic Lows?

In a speech at the Open University, The Bank of England’s Chief Economist, Andy Haldane explores why interest rates in advanced economies have got “stuck” and how policymakers should respond. Highly relevant given the recent BIS report which said there was too much reliance on risky low interest rate monetary policy.

Official interest rates in the major economies remain stuck at unprecedentedly low levels. Central banks have made vigorous attempts to dislodge them, including through special liquidity schemes, asset purchases and forward guidance. Yet interest rates remain stuck. This stickiness in interest rates has surprised both policymakers and financial markets. After they hit their floor, financial markets expected official rates in the US to unstick in 6 months, in the UK in 10 months, in Japan in 13 months and in the euro-area in 14 months. But they have remained stuck: in Japan for over 20 years and in the US, the UK and the euro-area for over 6 years. Indeed, the expected time to lift-off remains as many months away today as when rates first hit their floor: in the US 9 months, in the UK 10 months, in the euro-area 34 months, in Japan 72 months. In Australia, rates are as low as they have been in living memory, and some advocate further cuts still.

Real-Interest-RatesAndy explores two possible factors that may have contributed to current low levels of interest rates: “dread risk and recession risk. The first generates an elevated perception of risk, the second an asymmetric balance of risk. Both are relevant to explaining the path of interest rates, the likely fortunes of the economy and the optimal setting of monetary policy.”

The effects of dread risk have, Andy argues, “proved lasting and durable.” The fear of a further financial crisis and the risk-averse behaviours that follow help “explain the sluggishness of the recovery, and the adhesiveness of interest rates, since the crisis.” And, “if the past is any guide, these scars may heal only slowly.”

In a discussion of recession risk, Andy considers what we can expect for future growth on the basis of past trends. He finds that “the probability of an expansion lasting for longer than 10 years is, on past evidence, less than 10%.”

“If a recession were to strike in the period ahead, a relevant question for monetary policy is how much room for manoeuvre might be necessary to cushion its effects.” Comparing the magnitude of previous loosening cycles to the current path of the yield curve Andy finds, “recession probabilities exceed interest rate threshold probabilities by a factor of anywhere between 1.5 and 4.”

“Put differently, based on these estimates there is a considerably greater chance of interest rates needing to be cut to their floor to meet recessionary needs than of them gliding back to levels that could safely cushion a recession. Even after interest rates have lifted off from their floor, it is more likely than not they may return there over a ten-year horizon.”

What, therefore, are implications for monetary policy of continued dread and recession risk? Using the forecast from the May Inflation Report Andy has updated the interest rate trajectories he produced earlier this year. “As then, they suggest the optimal path for interest rates involves an immediate cut in rates for about a year, which pushes inflation back to target and closes the output gap. Thereafter, interest rates rise gradually in line with the market curve.”

However, the trajectories are illustrative and may “underplay the effects of risk” such as the dread risk and recession risk he has focused on here. He argues these risks have led to a cautious response to the recovery by both households and, to some extent, businesses which may “skew growth risks to the downside”. As a result, while April’s wage data was “encouraging news… one swallow does not a summer make.” “Wage growth is causing some fluttering, but not in this dovecote.”

This, in combination, with the downside risk to the MPC meeting its 2% inflation target two years hence, gives Andy “considerable sympathy” with the argument that interest rates should be “lower for longer” to manage the risks from raising rates too soon. A rate rise “however modest” would be a further example of bad news to already cautious consumers: “A policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow.”

This leads Andy to conclude: “my judgement on the appropriate monetary stance in the UK is relatively little altered from earlier in the year. The current level of interest rates remains, in my view, appropriate to assure the on-going recovery and to insure against potential downside risks to demand and inflation. Looking ahead, I have no bias on either the size or direction of future interest rate moves.”