Following three interest rate increases in 2006, Jan Barned reveals ways to manage interest rate volatility.
Last November the Reserve Bank of Australia announced an interest rate rise of 0.25 per cent for the standard cash rate the third interest rate rise for the year after the May and August rises.
The reason? Reserve Bank governor Glenn Stevens says it was done to curb the effects of a faster-than-average growing global economy, which is expected to increase its pace this year. 'Although growth in the United States has moderated recently, strong conditions are prevailing in other parts of the world,' he says. 'The global expansion has contributed to high levels of commodity prices, which continue to add to incomes and spending in Australia.'
The financial markets expected the rate rise.
But many believe, that given the current economic climate, it was too much too soon, given other economic factors. Petrol prices peaked at $1.50 during the second half of 2006, although at the time of writing there had been some retraction. The Australian dollar remained strong and there was no sign of the drought easing.
The Reserve Bank thought it had taken this into account, according to the governor. 'The board took careful note of the likely economic effects of the drought, which will lower the supply of rural produce, reduce farm incomes and may temporarily affect prices for foodstuffs,' he says. 'At this point, these developments appear unlikely to affect significantly the medium-term outlook for inflation.'
Many borrowers did not see the May 2006 rate rise coming, according to Paul Perry, associate director, institutional sales markets, ANZ Bank. 'In fact, in February/March 2006 a number of market commentators were talking of interest rate cuts,' he says. 'As a result borrowers who did not have a formal risk management policy in place did not hedge their interest rate exposures and were fully exposed to the 0.25 per cent increase in rates at that time.
'On top of the interest rate increase in May, two further increases have occurred,' Perry says. 'While many commentators predicted one increase, not many predicted the second increase until October when sufficient data, including CPI, ensured a rate hike in November.'
In order to monitor the effect each interest rate rise will have on the economy, the Reserve Bank takes a stepped approach to managing monetary policy. It is a fact that such effects are lagged, and given the strength of the economy and that borrowers did not anticipate the size and number of interest rate rises during 2006, it is likely the full effect to businesses and households will not surface until later this year.
Adam Donaldson, debt market strategist at the Commonwealth Bank, says the impact of 2006s rate hikes has been limited so far. 'Business lending has remained strong despite the rise in borrowing costs,' Donaldson says.
'Investment spending is still rising due to capacity constraints, particularly in the resources sector.
'Firms exposed to high commodity prices, or those with business concentrated in WA or Queensland, are doing very well. The fall-back in petrol prices and recent tax cuts have alleviated some of the strain households are facing from higher interest rates, so retail conditions have been firm. But we do think that households are starting to feel the burden of high debt levels and housing demand has cooled after a promising start to 2006.'
In order to minimise the impact of rising interest rates on trading conditions, organisations must understand the impact of interest rate movements on business. The best way to manage any financial risk, including interest rate risk, is to agree to a policy that will minimise the risk. The degree of management will depend on the level of risk that is acceptable to an organisation.
At OneSteel the interest rate risk policy is set by the board. 'This approach provides a cushion against interest rate volatility and opportunity to assess any business response needed to material movement in rates,' says treasurer Mark Hedges. Its a policy that has proved successful. As at the reporting date 30 June 2006, OneSteels debt was $658 million, and $402 million of this debt had been hedged. 'Fortunately, the rate volatility has been quite benign over the last few years. However, the recent interest rate rises have added cost to our business,' Hedges reveals.
Financial professionals manage interest rate risk by monitoring the yield curve. This is the anticipated forward interest rate over a period of time. The curve will be determined by the financial market forces of supply and demand over the duration of the period.
Such forces are governed by predicted future economic conditions and the likely impact on the economy. As such, the yield curve continuously moves to reflect expected interest rates based on predicted economic conditions and financial market forces.
At the beginning of 2006, as the rising interest rate cycle was not anticipated, the yield curve was relatively flat, and provided opportunity for those with formal policies to take advantage before the first rate rise in May.
'A number of clients have formal interest rate hedging policies in place, and accordingly were required to take fixed rate cover when rates were around 5.5 per cent in September 2005,' ANZs Perry says. 'Also the 90-day floating rates bottomed out around 4.5 per cent in the previous economic cycle. As a result, a number of clients took out long-term cover (five years and longer) when swap rates were below 5 per cent in June 2003. This cover remains in place.'
Currently the yield curve is inverted, indicating the present cycle of interest rate rises has reached its peak. Its expected that in the future interest rates will fall. Many believe that by hedging along the yield curve, borrowers can lock in lower fixed rates in comparison to 'riding out the storm' by remaining unhedged. Yet some may remain unhedged in anticipation of benefiting from a larger-than-anticipated (as reflected in the yield curve) drop in interest rates. This can be risky.
Effective hedging methods
There are many and varied products available to hedge interest rate risk, with the most common for longer-dated debt being interest rate swaps. An interest rate swap is when the interest rate commitment is swapped between two parties, usually the company and the bank.
Generally, to manage the volatility of interest rates, a company will swap from floating interest rate to fixed interest rate for an agreed period. Another hedging product often used is an interest rate option. This offers the flexibility of interest rate cover, with an option, as agreed between the two parties, on moving between floating and fixed interest rate cover. In addition, banks can provide structured transactions that have a number of different products embedded within them. Product choice should be dependent on the interest rate policy of an organisation, in line with its risk profile.
To ensure full transparency of risk, it is important when undertaking structured transactions, that participants understand the different products embedded in the transaction. What is interesting is the types of products that were transacted during 2006. As the interest rate horizon started to shift from the beginning of the year after the first interest rate rise, so too did the types of products organisations chose. 'Clients took advantage of the flat yield curve at the start of the year and actively used swaps to adjust their floating/fixed interest rate exposure,' Commonwealths Donaldson says.
'Towards the end of the year, we have seen an increase in use of more sophisticated risk-management tools such as options and forward-starting swaps,' Donaldson adds. '[The price of] options cheapened due to very low volatility in the wholesale markets after a brief flare-up around the middle of the year, so it is now more affordable to buy interest rate protection. Forward-starting swaps have become more attractive as the yield curve has inverted. This has allowed clients to extend the duration of their fixed-rate liabilities and lock in long-term funding costs at reasonable rates.'
The best method to manage volatility in interest rates is to reduce the level of debt. As Jamie Royal from Kaldi Coffee says, the interest rate rises have had little to no negative impact on his business.
'We currently have minimal debt, and therefore are somewhat insulated from any increasing serviceability issues,' he explains. 'If anything, the impact is positive for our business, as some of our competitors with service-ability requirements are forced to increase their prices.
'We have just purchased a large parcel of industrial land to develop a purpose-built coffee-roasting factory, and we recognise that the increased interest rates will slightly increase our costs. However, these increased costs are marginal when compared with the significant business advantages of the development.'
Will we see any further interest rate rises this year? Most of the commentators are suggesting the RBA will be 'on hold' for at least the first six months, waiting for clear signs its monetary policy action in 2006 was appropriate.
The rate rises we had to have?
When the latest interest rate rise will increase trading pressures under the current economic climate, many businesses will wonder why the increases had to happen at all. The Reserve Bank uses interest rates to control monetary policy, which is designed to influence monetary and financial conditions in order to steer the macro-economic environment, including inflation and economic growth. It is the banks role to support sustainable economic growth and a low level of inflation through the manipulation of monetary policy, namely interest rate movement.
The cash rate is set as a target rate, which influences financial market operations and guides behaviours towards the targets set ultimately supporting the macro-economic policies.
By adjusting the cash rate, the RBA is indicating to the financial markets the current stance of monetary policy, which will influence both financial market trading and provide a benchmark for the financial institutions on lending rates that will affect the decisions of businesses and households on the level they will borrow and lend.
In the early 1990s interest rates climbed to in excess of 20 per cent due to what many believe was poor management of monetary policy. But since then weve had a relatively stable interest rate environment. It is this stable environment that has seen significant economic growth, with low unemployment, increase in average wages, and low inflation. During this time, businesses have expanded capital expenditure, and household borrowing levels increased dramatically. It is these two factors that now provide concern following the latest rate increase.
