Monday 12 February 2018 by FIIG Securities canary Opinion

The reality of higher interest rates starts to bite

The bond market is the proverbial canary in the coalmine, frequently signalling dangerous market moves ahead of other sectors

For those listening, the canary has been singing with US 10 year government bond yields rising rapidly from the start of the year. The rate has gone from 2.40 per cent per annum to 2.80 per cent at the close Tuesday night. There were earlier warnings, when 18 months ago, 10 year US government bonds hit 1.36 per cent, thought to be the low point in the interest rate cycle. Now with rates at more than double that level, markets are beginning to believe easy money is coming to an end and US interest rates will move sustainably higher. Higher US benchmark rates will have global implications.

What was the trigger?

US economic data has been improving and figures out last Friday were positive for jobs and wage growth, great news. But, the robustness of the data had departing US Fed Chair Janet Yellen hinting there could be four interest rate rises this year instead of three, which spooked investors. 

What are the implications of higher US government bond rates?

US government bond rates are global benchmark rates, and pricing of just about any financial product you can think of is in some way influenced by these bonds.

For example, Australian banks borrow US dollars. CBA in its 2017 annual accounts had 45 per cent of its total debt issued in USD for an equivalent AUD75 billion. Higher US government benchmark rates means a higher cost of funding over time. These costs get passed onto mum and dad mortgage holders and statistics tell us Australian households have a burgeoning debt problem and can ill afford higher funding costs.

Higher funding costs combined with low Australian wage growth is likely to hurt, slowing consumer spending, impacting businesses, who ultimately could also be battling higher borrowing costs.

As investors absorb the implications – lower anticipated growth, lower expected earnings in time – they start assessing the attractiveness of other assets.

Higher US government bond rates also increases their relative attractiveness against other investment options. Theoretically, US government bonds become more attractive, so investors sell out of other global investments and currencies and back into USD, sending domestic currencies lower and the USD higher.

How did other types of bonds react?

When a benchmark moves higher, investors still expect to be paid a similar spread above the benchmark for the extra risk they are taking.

So, other types of bonds reacted as expected, yields on offer rose and bond prices declined. The Australian iTraxx, a proxy for investment grade credit spreads in Australia, was up nine basis points or 0.1 per cent to 64.5bps from 55.5bps over the week, a decent rise but historically still relatively low.

Looking at the Markit Credit Default Swap High Yield Index, composed of 100 non investment grade US entities rated in the single B and BB range, spreads rose from a low on Friday 2 February of 309.79bps rising to 335bps on Monday 5 February, translating to a price decline of USD1.14 from USD107.XYZ to USD XYZ. A loss, but much less than that experienced by shareholders.

The impact of the crossover

Aside from the market correction, another worthy key bond event is the likely "crossover" of US and Aussie 10 year government bond yields.

Australian government bond rates historically, have been significantly higher than US dollar government bond rates of the same term. However, while the US economy has been improving and government bond rates climbing, Australian rates have been relatively stable. USD 10 year rates are expected to surpass Aussie 10 year rates at any time.

Pre GFC, they were as much as 2 per cent per annum higher over 10 years, helping attract foreign investment to Australia and providing "carry trade". Borrow cheap in one currency, invest in higher interest rates in another and pocket the difference. Easy money.

The once consistent differential has disappeared and our interest rates, while still generally moving higher are not tracking US rates like they used to. 

Historically, the crossover would have been a big deal. Markets would have anticipated significant investment outflows as investors sell AUD government bonds and buy US government bonds for higher rates they provide. But in a very low rate environment – and as we’ve been heading to the ‘crossover’ for some time, the closing differential has not had such a great impact. One reason is that terms of trade have grown in importance with Chinese trade and solid commodity prices supporting the AUD. Another is that institutional investors need to invest minimum amounts in AAA rated sovereigns, and Australia still belongs to this small group.  

No one knows exactly how markets will react, so you’ll get a range of differing opinions. My best suggestion like that of many portfolio managers is to diversify. Hold a range of risk assets and if you think markets are looking expensive, hold a greater proportion of defensive assets such as deposits and bonds.

Bond investors should consider reducing holdings of longer dated fixed rate bonds and instead be adding floating rate notes (which adjust for inflation, a useful facility when inflation looks to be rising)*. The amount being paid for investing for longer or taking on greater credit risk has reduced, so think about selling higher risk investments for lower risk and improving the overall quality of your portfolio.

​Source: RBA, FIIG Securities


 *More information on Floating rate notes