Over the past three weeks longer term interest rates in Australia have risen very sharply even as short term rates declined and the Reserve Bank of Australia lowered the cash rate another 25 basis points to 2.00%
Is this a sign that the declining trend in interest rates has ended or is it an opportunity to take advantage of a temporary market dislocation?
Either way, right now is an opportune time for fixed income investors to reassess or reaffirm their views on the future direction of longer term rates and, if necessary, adjust their portfolios accordingly.
Below we answer the key questions regarding interest rates and the yield curve in Australia:
1. What is the issue?
2. How do interest rates and the yield curve affect me?
3. What should I do?
1. What is the issue?
Over the past three weeks longer term interest rates in Australia have risen very sharply from their historic lows. The yield curve (the difference between short term and long term rates) has steepened at the quickest pace since June 2013, with ten-year swap rates rising 63 basis points (bps), from a low of 2.66% to a high of 3.29% on Thursday 7 May (see chart below). Since then, rates have again contracted to be back down to 3.14% as at Monday 11 May.
The primary impetus for this move was a similar move in the US and Europe in April, as markets began to forecast sharply higher interest rates in those markets. This in itself seems counterintuitive since the Federal Open Market Committee (FOMC) has indicated it will continue to be patient before tightening rates in the US, and Europe is certainly in no position to consider higher interest rates. Rightly or wrongly, the Australian long term interest rates have a tendency to follow these types of movements in the US, so our long term rates began to rise abruptly in tandem.
Last week the Reserve Bank of Australia (RBA) lowered interest rates by 25bps, taking them to an all-time low of 2.00%.
The market reaction was unexpected, with a sharp move higher in longer term rates and a strengthening of the Australian dollar. This is not the impact the RBA would have anticipated. The reason for this reaction is primarily the notable absence of commentary regarding the expected future direction of policy, causing some commentators to claim this indicates an end to the easing bias. There has since been considerable criticism in the media of the RBA’s communication strategy, and the RBA’s position was clarified somewhat in the quarterly Statement on Monetary Policy released Friday 8 May (a link to that statement can be found here
).
After the RBA announcement, we learned of the most recent employment figures on Thursday, and they were very weak with 2,900 jobs lost. Of possible greater importance, there were 21,900 full time jobs lost, which was offset by a gain of 19,000 people in part time employment. Figures like these certainly do not give credence to any rate rise predictions.
The primary question now is: Does the recent move indicate a change in the long term trend of interest rates or is this a temporary dislocation, as in 2013, to be reversed over the coming weeks? From a technical analysis standpoint, there is resistance on the chart at around 3.40% in the ten year rate and that will be an important pivotal point in this conundrum.
Source: FIIG Securities, Bloomberg
*Note data accurate as at 11 May 2015 and subject to change.
2. How do interest rates and the yield curve affect me?
For investors with fixed income portfolios the primary concern surrounds the longer dated fixed rate and inflation linked products. The price of the bonds dropped given the inverse relationship with yields - and a continuation will cause a further fall in bond prices.
It is important to remember though that this is a short term valuation issue rather than a longer term profitability problem. Keep in mind that the worst case scenario (assuming there are no defaults in the portfolio) is a hold-to-maturity strategy in which case the returns will be commensurate with the yields at which the securities were purchased. However, as interest rates have fallen significantly over the past few years, many portfolios holding these fixed rate and inflation linked bonds are exhibiting implied returns to date (based on current valuations) well in excess of those yields. When the time is right, adjusting portfolios to crystallise those gains and moving to bonds less sensitive to interest rate movements is one of the primary objectives of active portfolio management.
Conversely, if this is a short term pullback and the downward trend resumes, this is an excellent opportunity to enter into these same bonds, locking in higher rates of return on longer term bonds. With cash rates now at 2% and many term deposits paying even less, investors who may have been unsure about the relative value in these assets are being given a second chance to build portfolios at attractive levels.
3. What should I do?
First and foremost, investors need to decide whether they believe this is indeed a reversal of the long term trend or a temporary pull back. For what it is worth, it is my personal view that the latter is the higher probability, but it is imperative that investors form their own independent view and act accordingly. Depending on your view, the recommended course of action is as follows:
Case A: We have seen the lowest point in the interest rate cycle and longer term rates are heading higher
- For existing portfolios, fixed rate and inflation linked bonds with very long maturity dates (10 years or greater) should be replaced with either shorter dated bonds or floating rate notes. This is especially true of longer term government and semi-government bonds, as these securities have no credit component to (potentially) offset the effect of higher base interest rates.
- Very long dated inflation linked products should be replaced, where possible, with shorter dated equivalents. A good example of this is for holders of the Sydney Airport 2030 capital indexed bond, which can be switched into the shorter dated 2020 bond from the same issuer. The credit risk and inflation protection remain the same, but the sensitivity to interest rate movements is greatly reduced.
- For new portfolios, keep to a smaller allocation to fixed rate bonds in favour of floating rate and inflation linked bonds.
Case B: This is a temporary pullback and we will re-enter the downward trend in interest rates
- For existing portfolios, look for short dated (2 years or less) fixed and floating rate bonds, and consider replacing them with longer dated fixed rate or inflation linked bonds.
- With term deposit rates now approaching (and in some case under) 2%, this is also a timely opportunity to replace these with longer term bonds as they mature to lock in a higher yield over a longer timeframe.
- With regard to the Sydney Airport example above in Case A, the obverse is a strategy worth considering: switching the 2020 bond for the 2030 equivalent will capitalise on any reversal of this short term correction in interest rates.