The interest rate cycle and the impact on asset finance

January 3, 2017

There are signs the interest rate cycle is at its bottom causing implications for asset finance. Just as interest rates rise, so too do borrowing costs.

Now that we are in 2017, it’s important to understand how the interest rate cycle is likely to progress and what will drive interest rate movements here and around the world.

Swap rates are the one of the first variables analysts look at when assessing interest rate movements. At the latter end of 2016, signs emerged to indicate a substantial widening of this spread. This demonstrates the market expects rates to increase.

The widening of swap rates has occurred in anticipation of the US Federal Open Market Committee (FOMC) lifting the cash rate at its 14 December meeting. This is one of the reasons why the market has re-priced risk, leading to the widening of swap rates.

In its most recent statement the committee noted, “The case for an increase in the federal funds rate has continued to strengthen.” But, it has, “decided to wait for further evidence of continued progress.”

The market has taken this as a sign the committee is prepared to raise interest rates from 0.5 per cent to 0.75 per cent. But, the market is not always right and it’s worth looking deeper into the committee’s statement to understand its rhetoric on future interest rate movements.

US non-farm payroll employment data is another variable taken into account when the committee reviews interest rates. Figures for September and August remained in line, leaving no strong signal from this data to help guide the committee’s decision.

Real GDP figures increasing at a moderate rate is a more positive sign the committee wants to see to make a case for a rate rise.

Inflation continued to run below the FOMC’s longer-run objective of two per cent, partly due to lower oil prices. This is an issue for the committee if it does wish to raise rates.

The FOMC’s goal is two per cent inflation. Currently, inflation is running at 1.6 per cent and is forecast to drop to 1.4 per cent. It will be difficult for the FOMC to lift rates if inflation continues to run below trend.

As noted in its statement, “when the committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of two per cent. The committee anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may warrant keeping the target federal funds rate below levels the committee views as normal in the long run.”

Additionally, the “survey measures of longer-run inflation expectations remained stable; market-based measures of inflation compensation moved slightly lower.”

While the market is pricing in a rate rise in December, this is not certain. As a result of this uncertainty, if you can lock in terms while interest rates are lower, your cost of borrowing will also be lower.

In Australia, it’s also likely we are at the bottom of the interest rate cycle. Reasonably strong GDP figures, healthy employment numbers and a lower dollar mean markets are not anticipating the RBA will drop the cash rate when it meets next week.

While it’s difficult to predict the actions of central banks towards interest rates for the remainder of the year, better economic conditions weaken the case for further rate reductions.

This is particularly relevant for customers refinancing or needing new asset financing solutions. Even if rates don’t increase in the US or Australia in the immediate term, now’s the time to lock in rates at today’s terms because next year, interest rate rises are on the cards.

 

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