_What does the negative interest rate debate reveal about the outlook?
Over the past week a number of signals have shed more light on global central banks evolving response to the crisis and market expectations of the future trajectory for interest rates.
Firstly, in the United States, the pricing of some US Fed fund futures contracts has shifted to reflect the expectation of negative interest rates by year end. Pricing in futures markets effectively reflects a probability-weighted average of market opinion, and while it is still unlikely that it will actually happen, many traders are now factoring it in as a possibility.
Secondly, in New Zealand, the RBNZ noted that ‘a negative official cash rate will become an option in the future, although at present financial institutions are not yet operationally ready.’
And thirdly, here in Australia the Australian Office of Financial Management was met with a record $53.4 billion of bids for a new 10½ year bond, ultimately raising $19 billion at a yield of 1.025% to help fund the recently announced fiscal stimulus packages to help shield the economy from the impact of COVID-19.
What chance of negative interest rates?
Each of these developments points to a sustained period of low and potentially negative interest rates.
In the US, the signal on the potential for negative rates comes despite repeated statements to the contrary from Fed Chairman Jerome Powell. But investors will have in mind that other major central banks in Europe and Japan have gone down this path despite similar initial misgivings. And New Zealand is the latest of a series of countries publicly considering such a policy.
There are mixed views on effectiveness of negative interest rates. Many academics point out that amidst a global recession, negative rates would safeguard against widespread corporate and government default. And further, that in a potentially deflationary environment they are needed in order to drive real interest rates below zero to boost the prospects of recovery.
Set against this, the experience of several countries points to the practical difficulties in implementing the policy and pernicious side effects such as reduced bank profitability, an undermining of consumer confidence and an erosion of incentives to maintain adequate financial buffers.
Attitudes differ by country, and they remain very unlikely in Australia with the RBA steadfast in opposition. But regardless of whether they eventuate, the signalling of negative rates as a possibility in countries that never would have dreamt of it a year ago points to the severity of the economic impact of COVID-19 and the likelihood that rates across the world will need to remain at rock bottom for many years to drive a sustained recovery.
Funding the COVID-19 induced deficit with ease
Meanwhile, this week’s monster Australian government bond issue reflects another side of the low interest rate dynamic.
With the government having announced a series of large fiscal packages including the $130 billion JobKeeper, the budget deficit will blow out substantially, driving up government debt. This necessitates the raising of an unprecedented quantum of funds through bond issuance. And the outcome this week indicates that the growing funding requirement will be comfortably met while maintaining low bond yields.
Australian government bonds are attractive to a wide range of international banks and fund managers, and the successful $19 billion raising attests to the weight of capital globally seeking secure income, capital preservation and exposure to the most liquid global currencies.
Furthermore, the yield of 1.025% points over a ten-year term points to the expectation of sustained low interest rates for many years to come.
What does it mean for property?
Sustained demand for secure income returns and the expectation that interest rates will remain even lower for even longer are clearly supportive for property, and can normally be expected to underpin lower yields, all else being equal.
But amidst COVID-19 all else is clearly not equal. Lower interest rates reflect a weaker economic backdrop and their impact is being offset by higher margins on debt finance and uncertainty over the outlook for occupier markets that will weigh on investor sentiment.
Yields will remain very low where income security is assured by rock solid covenants and long leases, and this will underpin support for prime property with long leases attached in major CBDs.
In markets more impacted by the economic downturn, however, the impact of low interest rates is less of a consideration than the perception of reduced income security and lower future rental growth expectations, which will see yields edging upward over coming months until occupier markets adjust and begin to recover.
For further information please contact:
Ben Burston
Partner, Chief Economist
+61 2 9036 6756