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Mind the interest rate gap

“Please mind the gap,” is a phrase most commonly associated with the space between the train and the platform, but this time it’s the gap between bank borrowing costs and official interest rates that has some markets worried.



“Please mind the gap,” is a phrase most commonly associated with the space between the train and the platform, but this time it’s the gap between bank borrowing costs and official interest rates that has some markets worried.
 
The London Interbank Offered Rate (LIBOR) for dollars has shot up this year and may experience some further upside in the short-term but this temporary gain should subside as the year progresses. LIBOR is considered the bellwether interest rate for global bank loans, mortgages and stock-market derivatives.
 
“In recent times we’ve seen an increase in bank funding costs and this has been a factoring into the volatility we are seeing in the sharemarkets,” says AMP Capital’s Head of Investment Strategy and Chief Economist Shane Oliver.
 
Last time LIBOR jumped significantly was during the 2008 Global Financial Crisis. Then, it was a sign capital markets had frozen. Banks were reluctant to lend to each other because of concerns about counter party sub-prime mortgage exposure.
 
This time, the reasons for the jump in LIBOR, are less sinister than the previous time, according to Oliver, though he warns the rise will still impact investors.

“There are two main reasons for the gap,” Oliver says. “The first being that the US has been borrowing more since the government agreed to raise the debt ceiling this year.”
 
“The second is that the US tax overhaul has meant that many US companies that used to keep their money overseas, usually in US dollars are bringing that money back to the US. Taking it out of the European markets dries up the supply available for short-term lending in the Eurodollar market.”
 
“So these things have all led to a bit of a squeeze, an increase in bank funding costs,” Oliver says.
 
In the short-term, this may be bad news for some Australian investors because it means that Australian banks may be paying more to borrow.
 
On a global level it could impact on illiquid sections of the high yield bond market as well.
 
“The longer this goes on, the greater the risk that Australian banks may raise their variable mortgage rates,” says Oliver. “Maybe not for owner-occupiers, but maybe for investors. So there is a bit of a risk around that.”
 
On the flip side though, if banks were to raise rates for investors it may be a factor for the Reserve Bank of Australia to further delay raising interest rates.
 
AMP Capital is now predicting the RBA won’t raise rates until 2020.
 
“So there are short term risks and it’s worth keeping an eye on them,” Oliver says.
 
“It’s also worth bearing in mind though that this is not the same kind of issue as what occurred during the GFC. Back then it reflected stresses in the banking system. This time around it seems to reflect the US government borrowing a bit more, and US companies bringing that cash back to the US.”
 

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