3% US 10-Year Government Bonds – for one day
As inflationary pressures continue to increase in America, we have seen bond markets continuing to price in a higher expectation of rate rises soon from the US Federal Reserve. Rising inflation, and the unwinding of US quantitative easing (QE), led the US 10-year government bond yield to move above 3% for the first time since December 2013.
It stayed at this level for only one day, but this breach of what had previously been the upper bound of yields caused the market to finally take notice of the real risk of interest rates moving higher.
The recent climb in the US bond rates means that US-based bond holders are finally getting a positive “real” return (the return after allowing for inflation) from holding these bonds.
As shown in the chart above, since late 2016 Germany, the UK and Japan have been providing local investors negative real returns on their government debt. Yields in these countries have also started moving closer to a positive real return, however still lag rates in the US.
Rising bond yields matter – because as yields rise the price of the bond falls. For example, if you purchased the US 10-year bond back in May 2016, for a gross yield of only 1.38% per annum the increase in rates to date would mean that your bond is worth approximately 11.3% less than what you paid for it two years ago.
The discussion on returns above does not cover any cost of buying the bond, tax, or fund management fee. If you add these additional costs, the overall return from such ‘low risk’ investments may become even more negative.
Given this we remain cautious about investment into the global bond sector, in particular longer-dated bonds that are more sensitive to changes in underlying interest rates.
Cost of borrowing closer to home
Domestic banks typically raise a large percentage of the funds they lend from offshore. As the London Inter-Bank Offered Rate (LIBOR) – which is the daily cost of banks’ lending funds to each other – has increased so has the cost of borrowing funds from offshore for the local banks.
We have heard anecdotal evidence that around 25% to 30% of the total New Zealand bank lending book is raised from offshore lenders at present. This means that interest rates on mortgages in New Zealand are likely to move higher, as interest rates increase in the US.
To date we have seen little movement in the shorter term local mortgage rates (in fact the 1-year mortgage rate has moved lower over the past two months). The banks’ ability to keep mortgage rates on hold as offshore rates rise has been mainly due to the recent decrease in demand for borrowing, as well as the Official Cash Rate (OCR) remaining anchored at 1.75%.
We expect this period of low mortgage rates to end soon as the cost of offshore funding continues to rise and the RBNZ finally starts to increase the OCR in early 2019. If the global LIBOR rate continues to climb then funding for all banks, both locally and globally, will become more expensive and mortgage costs could move higher sooner than expected.
Kiwis continue to have a love affair with local property, which is understandable when we consider the performance of this asset class over the longer term. Domestic property has been a stellar performer, but more recently we have seen the heat come out of the market with Auckland house prices only up 0.7% year-on-year, versus 6.80% year-on-year for the rest of New Zealand. We expect that rising interest rates may continue to provide a strong headwind to further growth in prices through 2018 and into 2019.
Australian banks under the microscope
We have seen Australian bank share prices tumble over the past few months as the Australian Financial Services Royal Commission inquiry continues to uncover extremely questionable lending and investment practices within the Australian banks. If you were only tuning in after the start of this enquiry the revelations are that shocking you could be forgiven for thinking you were watching a movie (think Wolf of Wall Street!).
The largest fall has come from AMP, which had been holding up very well until early February. AMP’s share price is now down almost 20% over the last year. We have seen the AMP CEO and Chairman both quit after the inquiry found that clients were being charged for services they never received. This issue was compounded when it was found that AMP executives attempted to mislead ASIC about the scandal and criminal charges could follow.
While many people were aware the banks may not be as trustworthy as they would have us believe, the enquiry has uncovered some shocking business practices to date. Commonwealth Bank of Australia (CBA -13.77% y.o.y) has been found to have approved lending applications on the back of fake payslips and other forged documents. The enquiry also found that there were cash stuffed envelopes changing hands to secure what are now being called “liar loans”. You might think that borrowers would do anything to secure funding, however this behaviour was actually from the bank staff!
The wealth management industry in Australia has over 25,000 advisers, all competing for A$2.6 trillion worth of savings in their compulsory pension savings scheme. This in turn is generating an amazing A$4.6 billion per annum in fees for the investment industry.
In the enquiries to date the Commission has found that in 75% of the cases reviewed the adviser could not show that they were acting in the client’s best interest.
The stories coming out of this enquiry underscore why we are proud to be independent with our advice, and why we have designed a business where the client is put first in all engagements. The enquiry is far from over, with no doubt many more revelations (and Director/Executive resignations) however it has posed the very real question of “can vertically-integrated organisations both manufacture product and provide advice that is in the best interest of investors?”.