The shape of the Watery Curve

By William Fong - May 7, 2018

The interest rates paid by borrowers can be plotted along cost of funding curves. In general, interest rates will be higher for longer borrowing periods – an upward sloping yield curve.

Read: Investment Month in Review - April 2018

Read: Royal Commission highlights the real value of independence

The Australian interest rate curves are usually influenced by two major factors: the first is domestic economic conditions and business funding requirements; and secondly it is influenced by the movements from global hard currency interest rate shifts, which are dominated by the USD curve.

After 26 years without a technical recession (the longest stretch ever among developed economies), Australia’s domestic environment is boring but not bubbly. The latest CPI reading is still forecasting an outcome that’s below the 2% - 3% targeted range of the RBA. This topic has been well reported, but in summary it comes down to an expanding workforce via immigration combined with changing national demographics to drive low wage growth despite relatively high employment levels.

Liquidity to the markets = water under the curve

The US economy, on the other hand, has had plenty of fiscal midnight oil pouring into the fully recovered and bubbly economy. The US Federal Reserve (U.S. central bank) is looking to raise official rates by up to 4 times this year alone, and more increases are expected during 2019/20. But it’s not tempering the growth engine as yet.

However, the particular shape of the USD yield curve, has flattened out substantially since 2014. The premium for borrowing for 10 years vs 2 years is now below 50 bps (0.5%) vs over 250 bps (2.50%) in early 2014 before the Fed began tightening rates. This has largely been due to the increasing short term borrowing rate set by the Fed, which is driving higher short term interest rate expectations, not being matched by expectations of rising borrowing costs for longer periods … to date.

The Figure below shows how the 2 year vs 10 year USD Treasury yield curve had been flattening out since the FED had begun tightening interest rate in 2014. 

Source: Bloomberg

The inflation dragon is stirring

But now, the decade old benign inflationary dragon has finally woken up. The dirty words of “term premium”, the additional cost for longer dated burrowing, are due to be “repriced”.

We believe that the global yield curve, led by the USD, will now enter a major steepening phase. The cost to borrow longer dated money, will most likely become a lot more costly than for short term funding. This is mostly due to renewed inflationary expectations in the global economy, with leadership coming from commodity pricing rises across the spectrum.

What else is going on with the interest rate curves?

Another recent headline topic comes from the widening out of the LIBOR vs OIS spread (in AUD form is the BBSW vs OIS spread), where LIBOR is the London Interbank Overnight Rate, OIS is Overnight Indexed Swap Rate and BBSW is the Bank Bill Swap Rate. To put this in layman’s terms, it’s the corporations’ capital funding cost versus the official central bank interest rate on a 3 month outlook. The widening out of the spread is an indication that investors think there are increasing risks to bank funding.

We don’t have to think back too far to see the challenge this increase in the spread can cause financial institutions. During the GFC investment bank Bear Sterns and other financial institutions found themselves in trouble in a very short timeframe due to skyrocketing interbank borrowing costs. This led to the collapse of nearly 2000 financial institutions in the mainland US alone.  

Source: Mason Stevens

What’s different this time?

In our view, the two key catalysts for the spread blowout on the USD curve this time revolve around:

1. The Trump administration’s tax incentive plan to lure offshore corporate cash back into the mainland tax system. This particular action has led to selling off offshore USD money market funds and movement of the cash back into onshore US treasury investments, deposits and equity buybacks in the USA. It created a shortfall of global LIBOR based USD funding outside that of the US.

2. Foreign banks operating in the US that use low borrowing costs of their parent company in their home market to fund lending to US business. Under the new tax regime, this is now taxable and means those banks can no longer solely rely on that particular funding path.  Thus US onshore LIBOR-based interbank borrowing requirements suddenly increased due to the rising demand for such funding, resulting in higher cost.

Will it lead to another GFC?

The short answer is no. Explanation of Reason 1 above created an overall reduction in the corporate tax bill for major global companies. It also allowed money to leave “parking funds” and back into potentially longer term infrastructure and capital investments on mainland US.  Despite the short term increase in deposits and US Treasury purchases, the low yielding vehicles would not justify companies changing their longer term cash return huddle levels.

As for reason 2 above, for the foreign banks to justify a large ongoing funding requirement onshore, they must be expanding their business progressively on the lending front. Hence, Net Interest Margin income would be booming for these subsidiaries.  Otherwise, why pay such high interbank funding costs to generate liquidity with the balance sheet (despite a closing tap from the mother ship back home)? This part of fiscal stimulus will lead to the expansion of the financial environment (rather than tightening of liquidity like it did during the GFC period).

Do I need to Panic? Not yet.

This has been a simplified explanation of what’s going on with one of the most sophisticated and broadly used financial instruments in the world.

The conclusive point is also coming from a friendly straight forward answer to the big question, “do I need to panic?” Short answer is “no”. The expected steepening of the yield curve is a case of ‘normalising’ from the recent conundrum of an overly flat curve, is in itself a positive development.

It will allow borrowed money to be priced more accurately according to the time value of credit. It will also help to address the USD $20 trillion of estimated retirement benefit income shortfall currently on corporate balance sheets due to the decade long compression of long term return yield (blame the Central banks).

As for the current widening of the LIBOR vs OIS spread, its causes are not something we should lose sleep over at this stage. But if the situation persists too much longer, it could damage our corporate sectors’ (namely big four Aussie banks) ability to tap the international funding market at below fair value liquidity.  We will watch this scenario closely.

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