Interest rates are drifting higher led by economic developments in the United States and China. In Australia too, bank lending interest rates have started to move up and may continue to do so, even though there are no signs of untoward lift in inflation or a lift in the RBA’s cash rate. Higher interest rates will place increasing pressure on those who have borrowed to the limit of their capacity to repay during the very low interest rate phase. The most vulnerable are predominantly corporate borrowers in the US and Asia, but the household sector in Australia.
The driving forces behind the lift in interest rates are accelerating global economic growth and signs that inflation is starting to lift. These signs have been showing since mid-2016 and independently of the later election victory of President Trump, although if his plans for a big lift in US Budget spending come to fruition (still a big if with opposition not just from the Democrats in Congress but a sizeable proportion of Republicans too) that would throw more fuel on the higher growth/ higher inflation fire.
It is fair to say that that the first signs of stronger growth and inflation flickering back to life caught investors disbelieving and so wrong-footed. By far the predominant view in mid-2016 was that the forces generating low-growth and disinflation bordering deflation were here to stay. Investors were over-weight in Government bonds even at near-zero interest rates or in some cases sub-zero interest rates. The unwinding of these positions was at times a touch frantic as investors faced the prospect that the predominant view of interest rates staying very low for longer was possibly wrong. The relatively pronounced sell-off in government bonds pushed up yields sharply in September through mid-December last year, but still to levels that were not unduly high – around 2.60% for a US 10-year Treasury yield and close to 3.00% for an Australian 10-year bond yield.
Nevertheless, this first phase of rising interest rates was enough to spotlight areas of borrowing especially vulnerable to higher rates – Asian corporates with their heavy load of US dollar denominated debt and Australian households borrowing from banks funded increasingly from offshore rather than domestic depositors. Australian banks have started to lift interest rates on various lending products – mostly housing investment loans so far.
The first phase of rising interest rates effectively paused for two months after the US Federal Reserve hiked its funds rate 25bps to 0.75% at its December 2016 policy meeting. The Fed’s rate hike came with a statement that the Fed would continue to watch the data to judge when to change rates, was waiting to see what President Trump’s policies would look like in practice and would most likely move rates slowly with possibly three hikes in 2017 (this from a Fed that heralded four rate hikes in 2016 and delivered one). There was a sense that although the Fed had hiked in December it was in no rush to catch up with the increases in bond yields, let alone promote the process.
Through February and early-March bond market views are showing signs of shifting again towards a faster-growing US economy with limited spare capacity potentially pushing the Federal Reserve to hike the funds rate more aggressively, possibly delivering at least the three rate hikes heralded for 2017. Views have firmed that the Federal Reserve may hike the funds rate by 25bps to 1.00% and provide indication that more rate hikes could follow relatively soon. The Federal Reserve has stressed repeatedly that it is data-driven in delivering funds rate changes. US economic data readings have mostly been strong, especially relating to employment. Also, US inflation has lifted on all measures above the Federal Reserve’s 2% target (the most recent CPI was 2.5% y-o-y) and looks like moving higher over coming months.
Much will depend on what the Federal Reserve does and says this week, but the risks are on the side of it becoming progressively more hawkish over coming months. A second phase of rising bond yields appears to have been developing over the past month and may push the US 10-year bond yield above 3.00% over the next few months and the Australian bond yield towards 3.50%. Australian banks are likely to experience another quite pronounced push up in their funding costs which they will probably pass on to borrowers. The squeeze on Australian households is just starting and not by design of the RBA but by whim of the global bond markets now fixated on how aggressive the US Federal Reserve will become.