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Who Wins When US Yields Go Higher?

For the first time in 20 years, 2-year US government interest rates have gone above 2-year Australian government interest rates. This is a significant turning point, and could signal the start of a new economic phase. Australian investors will need to be mindful of the consequences.

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Australia has generally always had higher interest rates than the US which has helped stimulate foreign investments into Australia by investors seeking yield and also to compensate for the less diversified economy of Australia vs. US.

So, what is happening now that is causing this to reverse and what are the potential outcomes?

Let’s start with what is causing the spread to reverse:

  1. The main reason is that US Federal Reserve started tightening in December 2015 and has since increased the Federal Funds Rate target 4 times to the current level of a range between 1.00-1.25 per cent while the RBA has in the same time period cut their cash target rate twice and is currently at 1.5 per cent.
  2. Even though the Fed Funds Rate is still below the RBA Cash Rate, there is also an anticipation that the Fed will continue to tighten as economic conditions in US continues to improve on back of strong asset markets, proposed tax cuts, recovering housing market and good consumer confidence while the consensus is that there is little chance that the RBA will tighten policy anytime soon on back of a peaking housing market, high consumer debt levels, weak consumer confidence and rising energy prices.

While there are many different implications from this trend, some of the more likely things we expect to play out are:

Scenario one. If RBA holds rates steady:

  • Investors that are seeking yield (insurance companies, retirees or anyone who is dependent on a steady cashflow stream) will probably look more to US than to Australia if they can get a higher yield in a more diversified economy. This will have implications for companies that run heavily leveraged business models (e.g. banks and other financial companies etc.) that rely on easy access to capital to fund themselves.
  • Interest rate parity suggests that this should be negative for the Australian dollar over time. This is good for Australian exporters with Australian dollar costs and foreign currency income as they get a free margin boost and bad for importers and retailers as it will make foreign goods more expensive in Australia so they will either face declining demand or a margin squeeze.
  • It is a positive for the domestic property market as it makes Australian assets cheaper for investors in foreign currency which might provide some support but we note that several Australian states have recently imposed penalty taxes on foreign investors potentially negating this effect.

Scenario two. If RBA raise rates to defend the AUD:

  • Rising rates would very likely have a very negative impact on the domestic property market as it is already starting to turn down and higher funding rates for the banks would likely be passed on to borrowers.
  • This would in turn have a very negative impact on overall consumption as the wealth effect we have seen the last years from rising property prices goes into reverse so again negative for retailers and also negative for construction as property developers are less likely to construct new buildings in such an environment.

As you can see, both scenarios are pretty negative overall. As we have written about before, the Australian economy has been driven by access to cheap credit and increasing leverage and rising interest rates in other market means that access to credit will be reduced in Australia one way or the other.

We believe that scenario one is the more likely at least in the short term as the RBA is unlikely to want to be blamed for any dislocation in the property market. Coincidently we are overweight exporters and generally underweight financial companies.

View More Articles By The Montgomery Team

Roger Montgomery is the Chief Investment Officer of Montgomery Investment Management, montinvest.com, and author of blog.rogermontgomery.com.

Roger's step-by-step guide to valuing the best stocks and buying them for less than they're worth, Value.able, is available exclusively at rogermontgomery.com. Skaffold is an online stock-picking application that rates ASX-listed stocks from A1 to C5. Watch a demo of Skaffold at www.skaffold.com.



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