March 2018

March 2018

Commentary

With the Beast from the East having come and gone, it is time to pack away the sledges for another five years and perhaps even dare to start thinking about spring time again. Ever watchful for a segue into the monthly market update, I got to thinking about the parallels between extreme weather events and the tail risks that our clients seek to hedge their businesses against such as very sharp and disorderly upward movements in interest rates.

Both come as a surprise versus our normal expectations and can happen rapidly and without much warning if the right set of factors come together at the same time. For the unprepared, the consequences can vary from unpleasant to terminal but with some sensible forward planning and management of the risks, most will be able to ride out the storm. Ten years or so of abnormally low interest rates, have created a “new normal” for corporate treasurers, where rising interest rates were seen as a real but perhaps far-off threat. The market has certainly taken this view, allowing many housing associations to lock in extremely attractive borrowing and hedging rates over the long term.

However, more recently, there has been a growing body of evidence to suggest that a) policy makers globally, led by the Federal Reserve in the US seeking to exit this long period of accommodative policy and b) the return from a long hibernation of the “bond vigilantes” which historically have kept profligate companies and governments in check. The charts below show the yield on ten-year US Treasuries – a bell-weather for global government bond yields and the consensus view of for future direction of short term US interest rates.

Source: Reuters, 28th February 2018

Source: Federal Reserve and LBCB analytics, 23rd February 2018

As ever, there are two schools of thought here. First is that we are at a secular turning point in interest rates and have seen the turning point in the 30-year bull market in bonds. This is supported by “chartists” who argue that key resistance levels have been breached, signalling a long-awaited turn in the interest rate cycle. On the other side of the debate are the perma-bears led by Albert Edwards of SocGen with his economic ice-age theory which argues that the current uptick in rates is a blip and that as a fragile global economic recovery stalls, bond yields will crash back to all-time lows.

Regardless of their views on the matter, the majority of housing associations manage their treasury portfolios on a conservative basis and even if they sit on the “lower for longer” side of the debate, prepare themselves for a higher interest rate environment given the asymmetry between upside and downside at current levels. Against this backdrop, recent turbulence in financial markets has seen some softening of spreads in the sterling bond market as shown in the chart below. While HA issuance continues to take place, the wider than expected spread on the long dated element of L&Q’s recent two tranche deal does suggest a degree of pricing caution on the part of investors, particularly where frequent issuers are returning to the market. The market expects to see a steady flow of housing sector issuance between now and the summer and through the remainder of 2018.

Finally, readers may be aware that there has been a recent update to the CIPFA guidance used by many housing associations as a template for their treasury management policy. It was last updated in 2011 but the changes are fairly limited. Interestingly, one area considered by CIPFA has been the increasing level of commercial investment by local authorities and what this means for treasury management, which clearly has a parallel with housing associations. We have recently updated the model Centrus policy to pick up relevant changes from CIPFA but also a few other developments in the market such as bank ringfencing and changes to the regulation of money market funds. Most associations have a regular cycle of changes to policy and we would be pleased to discuss this with clients, whether as a formal review in line with the normal timetable or on a more informal basis.

Financial Markets and Economics Overview

The significant sell-off in government bond yields in recent months has been driven by both rising inflation expectations and rising real yields. Both have been attributed to strong world growth, diminishing slack and the turn in the interest rate cycle.

With US and UK inflation expectations now in line with their historical averages, there may be limited scope for these to rise further. Instead, the bond market focus should be on where real yields go from here.

If confidence in the global upswing continues, the desire to spend and invest should put real interest rates under continued upwards pressure. But structural impediments to productivity growth mean any rise from this quarter is likely to be limited.

There are other developments that may also be expected to increase real yields. These consist of increasing budget deficits, particularly in the US following recent tax cuts, and the unwinding of central bank balance sheets. If central banks start to unload their QE bond purchases, the imbalance between demand and supply in the government bond markets is likely to see real yields rise.

With regards to data releases:

  • UK unemployment rate in three months to December rose from 4.3% to 4.4% – the first rise in over a year
  • There have been further signs of wage pressure, as UK regular pay growth accelerated from 2.3% to 2.5%
  • UK GDP growth was revised from 0.5% to 0.4% in Q4; but Q3 was revised from 0.4% to 0.5%
  • Household spending rose by just 0.3% in Q4 – further evidence of consumer slowdown
  • The £10bn budget surplus in January provided welcome news for the Chancellor
  • Weaker manufacturing & services pulled the euro area composite purchasing managers index down from 58.8 to 57.5 in February

After painting an unexpectedly bullish picture of the UK housing market in January, Nationwide said price growth had eased back again in February.  House prices grew at an annual rate of 2.2 % last month after a relatively sharp 3.2 % year-on-year rise in the January.

January’s data were at odds with more negative signs from a series of other indicators, including figures for mortgage approvals and the Halifax house price index. House prices fell 0.3 % between January and February.

Interest Rates

Inflation

Capital Markets

Bank Credit