MNI INSIGHT: RBA Perplexed, But Alert To BBSW Rise Impact

By Sophia Rodrigues

     SYDNEY (MNI) - The Reserve Bank of Australia isn't able to pinpoint the

exact reason for the increase in the bank bill swap rate (BBSW) but is mindful

of the implication for monetary policy if it becomes a persistent issue, MNI

understands.

     Since developments specific to the local market have led to increase in the

rate, the RBA has been exploring the reasons, but isn't yet convinced that any

of the many reasons cited by market participants explains it.

     The RBA is concerned because BBSW is a major credit-based benchmark for the

Australian dollar, and any rise affects approximately 65% of the total funding

cost for banks. The impact could be wider if banks raise their retail deposit

rates, and the RBA is closely watching that space.

     The 3-month BBSW was fixed at 2.0675 Tuesday, 57bps above the overnight

indexed swap rate which is at the same level as the 1.5% cash rate, given market

is not pricing any hike in the cash rate until 2020. Historically, the spread

between BBSW and OIS used to be around 15bps.

     --U.S. PRESSURES

     As reported previously by MNI, the pressures on money market rates began as

a knock-on effect from developments in the U.S. money market in Q1, eventually

putting upward pressure on rates in Australia.

     Some of it was wound back in the early months of Q2 but prior to end-Q2,

there was renewed upward pressure on money market rates, despite stable spreads

in the U.S. money market, and has continued.

     The RBA isn't discounting the possibility that it is becoming a

self-fulfilling prophecy -- because everyone is expecting the rate to go up, it

is going up. At the same time the central bank can't ignore the rising rate

because of its wider implications.

     --INITIAL MISCONCEPTION

     There was a misconception initially that the rate rise affects only the

short-term debt raised by banks, which is around a quarter. So the total effect

of a 42bps increase in funding costs was considered to be less than 11bps, not

enough to make a significant impact.

     However, the RBA estimates that because BBSW is a credit benchmark, it

affects not just short-term debt, but also new and some existing long-term debt,

along with wholesale deposits. It could affect up to 65% of the total funding of

banks and a 42bps increase would result in an increase of around 28bps,

equivalent to slightly more than one RBA cash rate hike.

     BBSW rates flow through to the rates that banks pay on new short- and

long-term wholesale debt. Banks tend to issue fixed-rate bonds and then swap a

sizeable share of these fixed interest rate exposures into floating rate

exposures to better aligns the rate exposure from their funding with their

assets. 

     But in doing this, they typically end up paying BBSW rates on their hedged

liabilities, which flow through to the cost of funding. 

     Wholesale deposits -- including deposits from large corporations, pension

funds and the government -- account for around 30% of banks' debt funding and

are also closely linked to BBSW rate.

     --RETAIL DEPOSITS

     The only main funding source for banks that is not affected by BBSW is

retail deposits, which RBA is monitoring closely as competition for funding

could push some banks to raise deposit rates.

     So far, a few smaller banks have raised their mortgages rates in reaction

to higher funding costs. If the elevated rates persist, it might eventually

trigger out-of-cycle rate hikes by the bigger banks and would mean tightening in

monetary policy.

     The RBA has shown reluctance to lower the cash rate but given both

inflation and wage growth remain subdued, it may also not want to see any

significant rise in interest rates. Depending on how this pans out, the RBA's

cash rate is likely to remain on hold for longer, with risk of a cut dependent

on how much mortgage rates rise and how widespread it is.

--MNI Sydney Bureau; tel: +61 2-9716-5467; email: sophia.rodrigues@marketnews.com

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