Friday 18 May 2018 by FIIG Securities housesup Opinion

Interest rates are moving even though the cash rate isn’t

Rising US interest rates are pushing up domestic BBSW rates. Review your bond portfolio and keep term deposit rates to a year or less

The Reserve Bank Board has kept the cash rate on hold at 1.5 per cent for a record 20 months since August 2016. But the more important reference rate for Mums and Dads is the Bank Bill Swap Rate known as BBSW and it’s on the move.

Simply, BBSW is a benchmark of observable rates of where the banks will lend and borrow to each other for certain future periods.

Higher BBSW benchmark rates means higher costs for banks. They’ll pass them on through higher fixed rate loans for new borrowers, and those with variable rate loans will also see interest costs and perhaps loan payments rise. As costs are rising, the banks will once again be reassessing which market is cheapest to raise funds and that may mean finally some prospect of higher deposit rates for savers.

How can interest rates rise if the cash rate hasn’t moved?

Our financial institutions borrow funds in many markets to on-lend at home. One of the biggest sources of funds is the US. Short term US interest rates have been rising as the US Fed has been increasing rates. Also a change in tax law means US companies can now repatriate funds from foreign markets without incurring a 32% tax charge and so are bringing home vast sums.

By withdrawing funds from international markets, they create a vacuum in those markets, forcing borrowers to offer higher rates to attract investment. As there are so many international investors and borrowers that use the US, virtually every country is impacted and short term costs rise across the board.

Let me give you an example. Westpac issued a fixed rate USD hybrid in September last year with a 5 per cent per annum distribution. As interest rates have gone up, the price of the hybrid has declined USD11 so that they are now trading below par USD89 but deliver new investors a higher 5.6 per cent per annum return. That means if Westpac were to issue a new USD hybrid it would need to pay around 5.6 per cent per annum to raise the finance. Ouch!

Not surprisingly, as it’s costing our banks more to borrow overseas, they are charging each other more and this is reflected in BBSW.  The 3 month BBSW had been tracking at about 0.25 per cent above the 1.5 per cent cash rate, until late March when it was 0.50 per cent or more, higher. More recently, 3 month BBSW has come off its high and is currently 0.40 per cent above the cash rate, still higher than recent averages.

Source: Bloomberg

The spike reminds us that there is growing volatility and markets can change quickly.

Higher US interest rates will see investors sell equities and buy bonds. The US 10 year government bond yield is up over 3 per cent per annum, well over many US dividend rates and it’s not hard to imagine something spooks the market and there’s a wide spread US equity sell-off. Why take the capital risk when bond yields are relatively appealing?

Australian equities have tracked US, so a drop in that market would see our market along with global equities decline.

This is the time to consider reducing risk in your portfolio.  High valuation equities look vulnerable as do long dated fixed rate bonds, as the earlier Westpac example shows. I would suggest investors add high quality floating rate bonds to take advantage of probable higher income as interest rates and BBSW rise.

Changes to deposit rates and our observations

The banks are always going to be quicker raising lending rates than increasing deposit rates. Higher sustained US rates feeding into Australian BBSW, should result in better domestic deposit rates over time.

Recently, the four major banks have been aggressive in raising funds in some term deposit maturity buckets. It’s worth keeping an eye out for specials and always talking to your bank manager before reinvesting.

Demand and the fact the four majors are prepared to offer higher rates, has impacted smaller banks and credit unions, who are struggling to keep up.

As of 16 May, comparison website Canstar, showed the top term deposit rate for a major four bank was 2.4 per cent from NAB, with CBA offering 2.55 per cent for nine months. Both NAB and Westpac were showing 2.8 per cent per annum for a five year term.

Regional ME Bank has been competitive across many maturity buckets showing 2.85 per cent for nine months and 2.80 per cent for a year. AMP and Greater bank are showing 3.2 per cent over five years, closely followed by ING at 3.15 per cent per annum.

Depositors can hope for higher interest rates over the next year, so I’d suggest you keep your options open with shorter terms.