Comments on: Cash rates and mortgage rates

By: Stubborn Mule

Stubborn Mule — Fri, 28 May 2010 06:56:34 +0000

Surya: predicting movements in the yield curve is tough. While the yield curve should provide a measure of future movements in the cash rate, it is the market's expectation so you face Keyne's beauty contest challenge. You are not so much trying to predict future movements in cash rates but predict what the market thinks cash rates will do. As for the relationship between Government bond yields, there is one. Very short-dated Government securities (Treasury Notes) tend to trade at a yield a little below the cash rate. So, in principle, longer dated yields reflect the market's forecast of a the cash rate...less a bit. The relationship between equities and interest rates can be tricky too. A simple argument would be that higher interest rates should be bad for equities either because you are discounting future earnings more or, equivalently, because corporate funding costs are going up. On the other hand, that assumes that earnings forecasts do not change. If interest rates are going up because the economy is getting stronger and/or inflation is on the rise, then that could be associated with increased earnings. Which effect will be greater? Hard to say!

By: Surya

Surya — Fri, 21 May 2010 12:26:35 +0000

Hi Sir,

Very Interesting post,

How would you predict the Yield Curve to change over the next month? and also what shape would you predict for this yield curve.

My second question is, what is the real relationship between the CASH Rate, and Government Yields (i.e. the relationship between the cash rate and the treasury yield curve).

My final question is, in these times of rising interest rates, where do investors turn? Debt (Bonds) or equity (stocks), and by doing so how does this impact on the yield curve?

By: Stubborn Mule

Stubborn Mule — Tue, 04 May 2010 11:13:25 +0000

Danny: a simple dividend-discount model would imply a negative correlation (higher rates mean bigger discounting of future dividends). However, there’s also the relationship between earnings growth itself and interest rates to think of. In broad terms, in business-cycle downturns, equities tend to fall and so to interest rates. The relationship between interest rates, inflation and equity performance is another angle to consider.

However, my earlier comment was more a reflection of what happened yesterday than on the broader relationship between interest rates and equities.

By: Danny Yee

Danny Yee — Tue, 04 May 2010 11:03:02 +0000

Thanks, that makes sense.

Are you sure bond prices aren’t linked to the stock market, though? There seems to be a pretty strong (negative) correlation to me, though I haven’t done any proper data analysis.

By: Stubborn Mule

Stubborn Mule — Tue, 04 May 2010 10:02:01 +0000

Danny: the relationship between government bond yields and the overnight cash rate (OCR) is not that simple. Although the RBA targets the OCR, it is in fact an inter-bank rate. While the change of a bank defaulting over a 24 hour period may seem low, it is still riskier than a government security. The tricky thing is that one-day government securities are not available. You can look at repo rates (which are loans with government securities as collateral) and overnight repo rates are typically below the OCR. You can also look at short-dated Treasury Notes (which have been issued again since March 2009 after stopping at the end of 2002). Unfortunately the water is muddied by the term structure between overnight and the maturity of the T-Note. But, as an example, on the 4 March T-Note tender, a 3 month T-Note was issued at an average yield of 3.973%. On that date, the OCR was 4% and, since markets have been expecting the cash rate to go for some time, a 3 month rate would be higher still. So, the starting point of a theoretical government bond yield curve starts below the OCR.

As for the 10 year bond yield move yesterday, while I wasn’t watching the market yesterday, it would not have been linked to the stock market (which itself was affected by the falls in resources stocks following the release of the Henry report and the government’s indication they would impose a resources tax).

By: Danny Yee

Danny Yee — Tue, 04 May 2010 09:38:26 +0000

A question for the fixed interest gurus. How is the RBA OCR related to the yield on government bonds? Is it as simple as the OCR providing the starting point for the bond yield curve?

I notice the yield on 10 year bonds dropped 4 basis points yesterday, presumably following the stock market down.

By: Stubborn Mule

Stubborn Mule — Tue, 04 May 2010 09:32:59 +0000

Senexx: one argument that rates will not go much higher is that, while the cash rate is still below average levels, according to the RBA mortgage spreads to the cash rate are about 1.3-1.4% higher in the wake of the global financial crisis (the result of those extra hikes I wrote about in the post). So, even if official cash rates are below average, mortgage rates are closer to some sort of average level (business lending rates have also increased more than the official rate) which means that the RBA may feel they do not have to raise rates as high as they have in the past.

By: Stubborn Mule

Stubborn Mule — Tue, 04 May 2010 09:05:52 +0000

This time around, the banks have been quick to pass on the rate increase but have not moved further than the RBA. Senexx: your memory serves you well. Late last year, Saul Eslake was forecasting a cash rate 4.5%. So far he's prediction is looking good. Of course, they may keep moving (Rory Robertson has suggested they may hike another 2% over the next couple of years)...we'll see in the coming months.

By: Senexx

Senexx — Tue, 04 May 2010 07:40:16 +0000

If I remember correctly 4.5% is what Saul Eslake approximated the new ‘neutral’ rate was going to be post-GFC.

By: Stubborn Mule

Stubborn Mule — Tue, 04 May 2010 05:33:20 +0000

The verdict: the RBA hiked rates by 0.25% up to 4.5%.