The curious case of funding costs

Like all businesses, financial institutions have input costs - things like labour, rent, technology and raw materials.

For financial institutions though the cost of a key “raw material” is the cost of money. Institutions like banks “rent” money from a variety of sources in the form of deposits or debt financing like bonds and bills.

" Now... relative stability has been jolted. And no one’s completely sure why." 

They then on lend this money (sometimes to other banks). Thus the cost of money is a fundamental variable in the business. Interest rates are the price.

During the financial crisis, observers pored over funding costs – at the acute phase of the crisis financial institutions could borrow money relatively reasonably for short periods of time but no one wanted to lend over longer periods – for fear the borrower would collapse and not pay the money back.

One of the key regulatory responses globally to the crisis was to force banks and others to rely more on more stable funding like ordinary deposits and long term debt and less on more volatile short term funding. Stable in the sense that deposits and long term debt (by definition) are not withdrawn at short notice en masse and their rates do not bounce around like wholesale funding.

In recent years, as volatility declined, we returned to a world where funding costs were reasonably stable. That said, new complexities entered the market: along with traditional drivers like the official interest rates set by central banks, regulatory costs and new prudential measures played into market prices.

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Now that relative stability has been jolted. And no one’s completely sure why. The message from official sources can be summed up as “be alert, not alarmed”.

In the latest minutes of the Reserve Bank of Australia monetary policy meeting, members noted corporate bond spreads in the United States and euro area had risen a little over March “which was likely to have reflected investor concerns about trade policies and reduced demand for corporate debt relating to US tax changes”.

“The increase in US dollar short-term interest rates appeared to have reflected a number of factors, including a sharp increase in US Treasury bill issuance in the early part of the year and changes to US tax arrangements, which had encouraged US subsidiaries of foreign financial institutions to source more of their funding from onshore US money markets,” the minutes said.

“In addition, demand for a range of money market instruments from a number of large US corporations was thought to have declined following changes to US tax arrangements.”

In the RBA’s view, developments in US money markets had flowed through to higher short-term borrowing costs in financial markets in Australia.

“In part, this reflected the use by Australian banks of funds raised in US markets to finance their domestic assets, in contrast to banks from other jurisdictions, which funded US dollar assets with the funds raised,” the minutes said.

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But the RBA is sanguine: “There had also been some flow-through to short-term interest rates in a few other markets, though to a lesser extent. Futures pricing suggested that these pressures in US money markets were expected to abate somewhat over the coming months.”

Even if it is short term, the rise in short term spread was unexpected. Given the global economic outlook – and granted there’s a lot of moving parts – it should be short term interest rates would remain lower while longer term rates would gradually rise.

That reflects expectations central banks around the world – with the notable exception of the US Federal Reserve – have pretty much said they won’t be raising rates in the immediate future. That’s the short end.

However, with economic growth expectations still robust on the whole, interest rates – official and market rates – in the future reflected in longer term debt today – would be expected to be higher. Rates tend to be higher with healthy growth and rising inflation.

Yet that isn’t happening. Short term funding costs have spiked. Longer term rates meanwhile don’t seem to be pricing in the economic growth seen elsewhere.

As Reserve Bank of Australia governor Philip Lowe said after the latest monetary policy decision to keep rates on hold: “Long-term bond yields have risen over the past six months, but are still low”.

As the latest RBA monetary policy minutes reflect, there are several potentially contributing factors, including rising US rates alongside a deteriorating US fiscal outlook (which requires the issue of more debt), but nothing specifically explains what is happening.

The changes in the US tax regime, which is leading to companies shifting money back to the US, is another possible cause.

This spike in short term funding costs may be just temporary, a new year market anomaly.

This year short term spreads, as measured by the ratio of the bank bill swap rate (BBSW) to the market’s pricing of official interest rates (OIS), have reached nearly 60 basis points compared with a more recent average of around 25.

That’s the most precipitous spike for a decade.

It’s meaningful even though regulatory forces since the financial crisis have shifted banks towards greater reliance on less volatile consumer deposits and longer term debt.

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All this comes at a time when official US interest rates rise above Australian rates for the first time since the crisis. This shift has major implications for currencies and debt.

Many a trader has gone broke trying to forecast interest rates and the complexities of the current situation are particularly … interesting.

With the major bank reporting season starting next week, there may be more information on how this is playing out.

But for the first time in nearly a decade, there’s more than market interest in the BBSW/OIS spread.

Andrew Cornell is managing editor at bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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