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August 2, 2017

August 2017 Outlook

The current interest rate environment is benign with shortened periods of volatility, generally settling down within two to three weeks. This is a pattern which has repeated itself for the past 18mths – 2years with little or merely passing interest from borrowers to address any debt and hedging exposures.

Indeed, a fair amount of activity which is identified, can often be attributable to a condition precedent (cp) under a lending facility, or very liberal percentages of hedging being maintained. But is this complacency warranted and is there risk lurking around the corner?

The short answer is that what the future holds is uncertain and there are people who pay money to others to predict what may unfold. However, there are a number of factors which should be considered and attention be devoted to. The time to address hedging and insurance is in fact when the markets are in low volatility mode, that may even appear to be apathetic. The analogy of buying straw hats in winter, is nearly always going to be cheaper than trying to buy one in the height of summer.

Whilst the past five years has been a period of declining interest rates both globally and domestically, it is becoming as clear as is possible that the RBA is no longer in rate reduction mode. This has been stated by the current governor of the RBA and whilst not envisaged or forecast for rates to rise in the near term, the cost of hedging should clearly be viewed as a benefit to eliminate risk and possible volatility out of a balance sheet.

The current drivers of rates are many, with offshore and a multitude of geopolitical events having influence on this. The opportunity to deploy risk management strategies at close to 2.00% and even below should be viewed as an opportunity not to be missed. We hear many corporates and clients respond to this by saying, there will be plenty of time when the market shifts upwards or when the RBA commences it’s tightening cycle.

The reality and our extensive experience has demonstrated that the market will be well ahead of any perceived move by the central bank and the cost of hedging will simply be more expensive. We also hear that property developers only hedge projects as and when required. This is absolutely accurate, however, on a portfolio basis most developers have a reasonable idea of future projects and it is possible to structure strategies around this core debt which will address the cp’s of many lending facilities.

Our experience has identified that clients can often be too busy addressing business as usual aspects and devote very little time to assessing and thinking about their current and future financial debt risks. It generally only receives attention when highlighted in the media several times and by then, has already been factored into market pricing.

Our view is that if rates are benign at lower nominal levels, the governor of the RBA has said that rates are more likely to rise as a next move (gold), then why wouldn’t borrowers address hedging at historically near all time lows?

Chart 1

The chart below are 3 year bond futures on a weekly basis. Previous patterns demonstrate that when the stochastic indicators seen in the bottom of the chart reach a high point, the market usually weakens or sells off. Another observation is that one moving average has crossed down with another. On the previous occasion that this occurred, the market moved from 98.46 to 97.81 – 65 bpts.

To put this into context, A$100m debt would incur an additional $1.950m in hedging cost from the high point to the low.

Most times when betting against the house, the house usually wins. In this instance the house is the RBA. Sure, on occasions they get it wrong with forecasts which are usually as a result of surprising data. However, when the RBA Governor is openly stating that the next move is more likely to be up why bet against the house especially when there is little premium being priced into curve.

Chart 2

The chart below is a curve comparison from February 2017 to current real time curve. As can be identified, rates are at lower than where they were six months ago. This clearly is identifying opportunity at more attractive levels than has been evidenced on a comparative basis.

For reference, fixed rates as at 22/8/17 based upon market convention. Please do contact us for any of your requirements.