Markets bet on little interest rate relief

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This is important because Norges Bank was one of the first developed world central banks to raise rates in September 2021, some eight months ahead of the RBA, which was watched with interest in the corridors of Martin Place. Notwithstanding its late start, the RBA quickly made up the lost territory and has cumulatively jacked up rates by more than its Norwegian contemporary.

The RBA has also been ahead of most peers in reducing the pace of its interest rate increases from 50 to 25 basis point increments in October 2022, and examining the possibility of an outright pause at its December meeting. These back-to-back increases in rates over many months are not normal: the RBA has historically averaged a gap of about 1.8 months between each rate rise based on analysis of its increases since 1984.

There have been some striking commonalities between the RBA and Norges Bank’s historical cycles, which is not that surprising given the cointegrated nature of the global growth and inflation pulses. Both central banks cut rates at about the same time in 2008, after hawkishly lifting them that year before it became clear that the global financial crisis would crush demand. They then stopped easing and began boosting rates again in 2009 at similar junctures. While the RBA paused in 2010 ahead of the Norges Bank cycle, they were concurrently chiselling rates lower in late 2011.

Revised estimates

Following weaker global inflation data and a soft local employment print (the Aussie jobless rate appears to have bottomed out), markets have radically revised their estimates for the peak of the RBA’s current cycle.

As recently as October last year, investors were pricing in a terminal RBA cash rate of north of 4.3 per cent. They have since pared that back to 3.5 per cent, which is expected to be reached in August this year. This implies that the RBA has less than two standard 25-basis-point rate increases left to go. And while investors are nervous about the RBA’s next February meeting, which will doubtless be heavily influenced by the tier one inflation data published on January 25, they are still pricing in a 60 per cent probability of another 25-basis-point increase. (For the avoidance of doubt, we don’t trade or bet on RBA decisions.)

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Curiously, the market is only pricing in an incredibly modest easing cycle with a trough for the RBA’s cash rate of 2.85 per cent in October 2024. That would be about one cut from the current cash rate, or 2-3 cuts from the peak rate in August this year. Put differently, the market is signalling that high interest rates are here to stay.

That assumption does not necessarily jive with the historical record. Examining the magnitude of RBA cutting cycles since 1996, we find an average decrease of 225 basis points.

A protracted period of elevated rates would be grim news for property investors and any borrowers hoping for interest rate relief. House price declines have displayed no signs of abating in 2023. Sydney dwelling values have fallen another 0.9 per cent over the first 20 days of January based on CoreLogic’s data, bringing the cumulative losses in Australia’s largest city to 13.5 per cent. Across the five biggest cities, home values have fallen by a total of 9.5 per cent – they should pierce the 10 per cent threshold next month.

Win for savers

While borrowers are being punished by the higher cost of capital, savers are obviously profiting. Whereas term deposit rates above 0.5 per cent were hard to find in 2021, you can now get specials from some banks around 4 per cent. In the bond market, we have recently seen banks like Bendigo offer safe and liquid senior-ranking bonds paying annual interest rates of almost 5 per cent (we picked up some).

Yet there are arguably even more attractive deals going around. For example, both NAB and Macquarie have had to pay very high interest rates on their Tier 2 bond issues in US dollars recently, which carry the same credit ratings as Bendigo’s senior-ranking debt securities. NAB’s Tier 2 bond offered 6.43 per cent annually, while Macquarie’s paid 6.80 per cent (in local US dollar terms). Swapped back into Aussie dollars, these bonds delivered more than 7 per cent annually. (We bought both.)

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There appears to be a bit of an anomaly in the Tier 2 market, which in both Aussie and US dollars is trading on credit spreads above the cash rate that are even higher than lower-ranking and lower-rated hybrids issued by the same banks on the ASX. While there are many potential explanations for this unprecedented situation, one candidate is simply the fact that investors in listed hybrids do not price, value or trade them on a spread to cash, but rather focus on the all-in yield.

On this basis, major bank hybrid yields appear extremely attractive relative to their levels in recent years. For example, current five-year major bank hybrids are pricing in an annual running yield of about 5.65 per cent, which implies a spread above the quarterly bank bill swap rate of 2.38 percentage points.

Back in January 2021, five-year major bank hybrids were trading on spreads above the bank bill swap rate of three percentage points. Since the bank bill swap rate at that time was only 0.01 per cent, the running yield on these hybrids was also around 3 per cent. So, even though major bank hybrids are trading on spreads some 62 basis points tighter than their levels at the start of 2021, the all-in running yield is 265 basis points higher because the bank bill swap rate has leapt from 0.01 per cent to 3.27 per cent.