(Bloomberg) -- Blame it on a piece of financial plumbing.
A gauge of borrowing costs for Australian banks, the three-month bank bill swap rate, has jumped 22 basis points in March, heading for the biggest monthly gain since September 2010. What’s behind this? One of the reasons can be found 10,000 miles away with the rise of U.S. dollar borrowing costs, but another is closer to home: the local repurchase market.
Rates have been surging in Australia’s repo market, which bondholders use when they need to borrow cash. The increase in the secured borrowing rate is helping push up the unsecured funding rates that banks have to pay. This in turn has driven the three-month bank bill fixing to the highest since 2016 even though the Reserve Bank of Australia isn’t getting any closer to raising interest rates.
1. So, it’s not just a spillover from rising U.S. rates?
That’s one of the drivers. There used to be an advantage for Australian banks to borrow funds in the U.S. dollar market and swap them back into Australian dollars, but not any more. The jump in U.S. bank borrowing costs and an uptick in the cross-currency swaps have effectively ruled this out. This means that more banks now need to borrow domestically, which adds to the upward pressure.
2. What then is driving up repo rates?
Banks have deposited more bonds into the repo market, which is sucking out the available cash and pushing rates higher. There’s no convincing data to explain why. The best answer from strategists is that a step-up in demand from overseas investors is behind the move.
For instance, Japanese investors may pledge Japanese government bonds for Australian debt, and then put the latter in the repo market to get Australian dollars which they then use to buy higher-yielding assets. Everyone benefits.
3. Why are U.S. dollar borrowing costs rising?
Six Federal Reserve interest-rate hikes since December 2015 and an increase in Treasury bill issuance to fund U.S. budget deficits have been sending dollar funding costs higher.
4. How long will Australian repo rates keep rising?
Difficult to say. There’s a seasonal impact in play, as rates typically edge higher toward the end of each quarter, and then decline once the new period begins. This may not be the case this time however, as the size of the increase suggests there may be more impact from overseas investor flows. Still, the bank bill futures market is pricing for the impact to fade from the start of April, with June implied yields trading below current levels.
The quarter-end increase in repo may also be associated with banks adjusting their balance sheets for reporting purposes, a process widely known as window-dressing. They basically reduce their credit lines and become more reluctant to lend.
“The consensus view is that April will see an easing in conditions with half-year over for three of the four Aussie majors,” says Mark McKendry, head of Australian dollar rates trading at RBC Capital Markets in Sydney. “But even if this happens, repatriation of offshore dollars is causing a fundamental adjustment in short-term funding markets.”
5. If borrowing costs keep rising, what are the implications?
If higher rates are prolonged, the increase in bank borrowing costs points to two possible implications. Banks could simply absorb the higher costs themselves, in which case the impact would be limited. Alternatively they could pass them onto consumers via higher mortgage or loan rates. This would tighten money supply and crimp economic growth, similar to the way in which the RBA would tighten policy. This would be somewhat ill-timed, as the market isn’t expecting any move from the central bank until the start of 2019.
“If that was to be sustained for a length of time, it would cause the banks to pass on their costs to maintain margin and that will act as a tightening of financial conditions across the economy as credit becomes more expensive,” says Damien McColough, head of fixed-income research at Westpac Banking Corp. in Sydney.
6. How can investors deal with rising bank bill rates?
Strategists recommend that investors turn to the futures market. If they want to avoid any risk of changes in rate hike expectations by the RBA, they can use bank bill futures versus overnight index swaps, which operate as a proxy for RBA rates. Alternatively, Morgan Stanley strategists recommend selling Australia bank bills to buy New Zealand ones.
©2018 Bloomberg L.P.