Watch out for interest rate risks

{www.afr.com/news/economy/interest-rate-risks-rise-20151105-gks9ym}

While the Reserve Bank of Australia was not inclined to cut rates in November, it certainly looks like Federal Reserve chairwoman Janet Yellen will find the courage to lift her cash rate off its near-zero level on December 16, some seven years after the global financial crisis first hit.

Since RBA governor Glenn Stevens regularly communicates with Yellen, he may have been privy to her thinking on this subject, which could explain the RBA’s decision to pause with an easing bias. As far and away the most influential actor on the global price of money, the first Fed hike is a big deal for markets and should put downward pressure on the Aussie dollar. Expectations around this event have helped push up the interest rate on 10-year Australian government bonds from just 2.58 per cent on October 5 to 2.82 per cent on Friday.

With the Bank of England’s governor, Mark Carney, also announcing on Thursday that it would be "prudent" to think "rates are likely to go up in the next year", we could see two of the world’s most important economies coerce a repricing of interest-rate risk at the long end of the yield curve, which would be generally bad news for equities and fixed-rate bond investors. (Sometimes early hikes are correlated with equities rallies insofar as they portend superior growth prospects.)

Recall that long-dated government bond yields are used as the "risk-free" discount rates in valuation models to price uncertain cash flows deriving from all asset classes, including equities, bonds and property. These risk-free rates have been in secular decline for almost three decades, which has boosted the present value of all income streams (especially leveraged ones) and provided a powerful tailwind for shares, commercial and residential real estate, and fixed (not floating-rate) debt securities.

My central case is that the Fed allows the US jobless rate to decline below 4 per cent over the next 18 months, which will animate benign wage inflation and embolden markets to radically reassess the Fed’s rate profile. I think there is a decent chance policymakers and governments make errors in setting excessively stimulatory cash rates and chasing inflation in a bid to debase the real cost of their ever-growing debts. An unanticipated spike in global inflation could prove to be the "surprising" cause of the next shock, and trigger developed-world sovereign defaults. Needless to say, this would be cataclysmic for markets. Optimistic stuff, I know.

INFLATION WINS OVER PARSIMONY

Intellectually, we’ve had wins over recent years on our forecasts for house-price growth, credit-fuelled bubble risks, the introduction of macro-prudential rules to attenuate credit creation, bank recapitalisations and mortgage risk-weight increases, and extreme losses on hybrid securities. The last man standing is inflation, and I am betting that politicians’ myopic self-interest will prevail: given the choice between inflating your way out of your debts and parsimony, the easier road will win. History suggests tame inflation is the exception rather than the rule in economies with "fiat" money (non-asset-backed money underwritten only by the credibility of governments) and persistent fiscal deficits. Much easier to print money and self-finance As one trader wrote: "It’s QE to infinity."

During the week Stevens argued that while the net impact of the banks’ (unilateral) rate hikes on home loans was equivalent to half a 0.25 percentage point increase in all business, personal and residential borrowing costs, many lenders had, in fact, chiselled rates over 2014 and 2015 by much more than the RBA’s three cuts since August 2013. (We first highlighted this dynamic in June last year.) He was indicating that there may not, therefore, have been a net tightening.

Stevens also bought into the banks’ return on equity debate, which is a change of heart for a central bank that has over the years bent over backwards to defend the oligopoly’s profits and the state of competition in the name of misguided financial stability aims. (The RBA claimed there was a trade-off between stability and competition – I’ve counted the two factors can be positively self-reinforcing.)

"I am not offering an endorsement of the banks’ actions," Stevens said. "Nor should an assumption that shareholder returns must not decline as a result of the effects of supervisory measures…simply be accepted without question," he clarified. "The ‘right’ rate of return for bank shareholders is, as others have observed, an open question – it is not a constant of the universe."

We’ve been saying the same thing for years. UBS’ banking analyst, Jon Mott, likewise commented this week that he was "surprised Westpac maintained its return on equity target of greater than 15 per cent after the announcement of higher capital requirements, especially as this implies a return on tangible equity target of more than 19 per cent". "Is this justifiable in a 2 per cent interest rate environment?" Mott asked. "While banks must be able to generate returns above their cost of capital…just how far above remains open to debate." Too right.

RETURNS WILL BE LOWER

Bank returns are bound to head lower as they still need to raise more equity capital. Don’t get me wrong: the big four have done a fantastic job sourcing $33 billion in new equity over the last year and, as the Australian Prudential Regulation Authority’s boss, Wayne Byres, observed on Thursday, "the relative positioning of [their] capital ratios against their international peers is much closer to that recommended by the financial system inquiry".

Yet as CBA’s credit strategist, Scott Rundell, highlighted, APRA’s new estimated minimum CET1 ratio is 10 per cent and the majors are sitting between 9.1 per cent and 9.4 per cent (pro-forma for the 2016 increase to home loan risk weights). That implies they are still short another $11 billion of equity, which they can comfortably originate over the next year or two. Coupled with single-digit credit growth, a normalisation in bad debt provisions and intensifying competition, I expect their returns on equity to stabilise in the low teens.

Next week the world will see the Financial Stability Board’s (FSB) final "total loss absorbing capacity" (TLAC) rules to mitigate the risks of too-big-to-fail banks. All the majors have officially reported "total capital" ratios, which includes their loss-absorbing instruments, equal to 18 per cent of risk-weighted assets (on an internationally harmonised basis). This is notably above the FSB’s TLAC target of 16 per cent for entities classified as globally systemically important banks (GSIBs). (The majors’ total capital numbers include their capital conservation and systemically important buffers.)

On TLAC, Byres said: "Australia has no GSIBs", which means the rules do not technically apply to the majors. And while Byres is committed to ensuring the majors have adequate TLAC, which they arguably already do, he cautioned that "the FSI suggested Australia should not get ahead of international [TLAC] developments, and this is an area – perhaps more than most others – where the devil is in the detail, it makes good sense that we hasten slowly".

This is sensible stuff from APRA, which is appropriately focused on prioritising going-concern capital in concert with culture, governance and remuneration, and thus reducing the risk of problems arising in the first place. It would be unfairly harsh to require the majors to have world-beating risk-weighted equity and leverage ratios, and go further than most peers on TLAC, especially when our senior bonds are not currently eligible for TLAC whereas US and European senior bonds are. This would give the latter a distinct funding cost advantage. Here Byres said that while APRA will monitor "international developments, it will clearly be important to consider what best suits the particular characteristics of the Australian financial system". I expect TLAC to be a non-event for the majors.

REGULATORS TAKE TOUGHER STANCE

To their credit, Australian regulators have been belatedly manning-up on the banks across the board. On Thursday the RBA’s "concerned" and "surprised" Phil Lowe revealed that regulatory investigations discovered that 10 banks, including two majors, had conveniently misclassified $50 billion of investor loans as (arguably lower risk) owner-occupied products. This resulted in the speculative share of the mortgage market jumping from 35 per cent to a record high 40 per cent. (A company I founded spent years enhancing the RBA’s house price data, which Lowe said "helped improve the general understanding of housing market developments".)

The RBA is also to be congratulated for adopting a sophisticated "Merton model" for assessing corporate credit risk, which is an upgrade to its real-time risk monitoring. I use Merton’s option pricing methods to quantify the probability of default on bonds and the RBA says "the model’s ability to identify risks stemming from the real estate sector in 2008, and the deterioration in financial health in the resource sector more recently, indicates the value it adds".

The smartest thing bank bosses could do right now is cut their crazy dividend payout ratios and invest in innovation, which is the only panacea for long-term growth.

Christopher Joye is a director and shareholder in Smarter Money Investments, which manages fixed-income investment portfolios.

Read more: http://www.afr.com/news/economy/interest-rate-risks-rise-20151105-gks9ym#ixzz3qh4h3EaE
Follow us: @FinancialReview on Twitter | financialreview on Facebook

---

Archr LLP is Authorised and regulated by the Financial Conduct Authority (FCA reference 617163).
Archr LLP is not covered by the Financial Services Compensation Scheme (FSCS).
Archr is registered in England and Wales No. OC371018. Registered office Chancery House, 30 St Johns Road, Woking, Surrey, GU21 7SA

This message may contain confidential or privileged information. If you are not the intended recipient, please advise us immediately and delete this message. The unauthorised use, disclosure, distribution and/or copying of this email or any information it contains is prohibited.

This information is not, and should not be construed as, a recommendation, solicitation or offer to buy and sell any securities or related financial products. This information does not constitute investment advice, does not constitute a personal recommendation and has been prepared without regard to the individual financial circumstances, needs or objectives of persons who receive it.

You are receiving this email because you are a valued client of Archr.