For the first time since late 2000, the spread between Australian and US 2-year bond yields has turned negative, with US 2-year bonds yielding more than Aussie 2-year bonds.
While the immediate market focus is on the implications for the Australian dollar, Merricks Capital CEO Mr Adrian Redlich says there is an added benefit for US investors wanting to take advantage of Australian investment opportunities.
The Merricks Capital senior lending portfolio is currently achieving rates of return in excess of 10%. These attractive returns are now achievable in US dollar terms as well as Aussie dollar terms, as there is limited cost in hedging.
Mind the gap
The interest rate cycle in the US and Australia has increasingly become out-of-sync. The US Federal Reserve (the Fed) first raised interest rates, post GFC, by 25 basis points in December 2015. After a 12-month hiatus, rates were again raised in December 2016, then again in March and June, for a total of 100 basis point increase.
In contrast, the Reserve Bank of Australia (RBA) has yet to raise interest rates and the last move in official cash rates was a 25-basis point cut in August 2016.
This diverging monetary policy activity has resulted in a narrowing spread between Australian and US bond yields and, going forward, it is likely that the trend will continue.
The Fed is universally expected to raise rates at the next meeting in December, with the magnitude of the increase the major point of contention. The CME FedWatch tool shows markets are pricing in a 90% change of a 25 basis point increase and a 10% chance of a 50 basis point increase.
The Fed’s own median “assessment of appropriate monetary policy” sees rates rising a further 75 basis points next year and more than 50 basis points in 2019. On this basis, US bond yields could be expected to continue increasing from historical lows.
The outlook in Australia is again quite different and the RBA is expected to leave interest rates unchanged until at least the second half of 2018, with only a 60% likelihood of any increase at all over the next 12 months. While the RBA has stated that the next move in rates will be up, the
timing of any increase is being pushed back as key economic data such as wages growth and inflation continues to miss expectations. The outlook for bond yields is subdued as a result and the pace of any increase is likely to lag the cycle in the US.
In addition to downward pressure on the Aussie dollar as money (theoretically) flows to markets and currencies where returns are higher, the narrowing AU-US bond yield spread has a significant practical outcome for US investors. It removes the cost of carry for hedging Aussie dollar currency exposure.
When Australian interest rates are higher than US rates, as has been the case historically, forward exchange rates are lower than the spot rate. This means hedging an Australian dollar exposure, or selling Aussie dollars forward, has typically involved a cost. The convergence of interest rates has eliminated this cost.
Senior lending opportunities are becoming increasingly attractive
Merricks Capital’s Mr Redlich says it’s a good reason for US investors to consider investing in Australian assets. In particular, he says there are a number of attractive investment opportunities in the senior lending space as a result of recent changes in the property financing market. Regulatory measures designed to improve lending practices, including restrictions on interest-only lending and measures to limit the growth in investor lending, have seen the major banks reduce their exposure to investment lending. “This has created a void in the property financing market, and the reduced competition has led to an increase in investment yields.”
While returns are attractive, the underlying fundamentals for the Australian property market, particularly quality projects by quality developers, remain largely positive. Mr Redlich says the transformation of the property financing market is resulting in the unique situation where impressive investment returns are combined with limited risk. Most importantly, the latest developments in interest rate markets means investors can now hedge any currency related risk with no cost, increasing the attractiveness of Australian assets to US investors.
“We have previously talked about the perfect storm of investment potential in senior lending, and we continue to see outstanding investment opportunities due to the cur- rent market dislocation. Now, for the first time in 17 years, US investors can also hedge their currency risk at virtually zero charge, reducing the ‘cost’ of investment.” We believes it’s a good time for US investors to consider investing in Australian assets, particularly by taking advantage of the significant returns and low risk profile available through senior lending.