Rates in a bind amid bond market moves

Can interest rates rise and fall at the same time? They can if you’re looking at different markets, because just as the Reserve Bank of Australia considers a fresh cut in its prime rate to try and boost the local economy, interest rates in other markets are starting to rise.

Most Australians are more interested in what the RBA might do in coming months, with some analysts forecasting that the current rate of 2.5 per cent will drop to as low as 1.5 per cent by Christmas.

Helpful as that might be for anyone with a mortgage, it could have the effect of further inflating property prices just as there are other, far more significant, interest rate changes under way; including a surprise rise in government bond prices here and overseas, which has been a major factor in recent stock market turmoil.

The big move on the Australian market during the past few weeks has been in 10-year government bonds, which have risen from around 2.3 per cent to their latest price of 2.6 per cent.

Bonds are the primary mechanism for governments and big companies to raise debt, and it is the price of debt that plays a crucial role in setting the price of everything else.

Big changes have been under way in the bond market during the past month, with rising interest rates producing a corresponding fall bond prices that has, in turn, led to a fall some other asset classes, including shares.

The Australian stock market, while seemingly driven by commodity prices and the dividend flows from the big four banks, has been falling under the spell of bond market changes and the threat of big capital raisings by the banks – thanks to their heavy reliance on property lending.

However what’s happening here is nothing compared to what’s happening in Europe, where vast amounts of money has slipped into a bizarre world of negative interest rates, a system that means you pay the bank for holding your money.

One recent estimate is that 30 per cent of all government debt in Europe, around €2 trillion, is now earning (if that’s the right word) a negative interest rate.

Why people would buy a bond that costs them more money from the day it is acquired is as interesting from a psychological perspective as from a financial one, because it shows that there is a preference for parking money safely (at a fee) than seeking a return.

Overnight, negative interest rates in Europe showed signs of cracking. A German government attempt to raise €4 billion fell short of the mark, with the five-year bonds attracting just €3.65 billion.

The German surprise was followed by a bloodbath in the bond market, as almost $100 billion was wiped off the value of all European government debt, thanks to a modest rise in bond rates. The bellwether 10-year German bond rose by 0.12 per cent to 0.28 per cent.

What happens next is the interesting thing, because if European bond rates continue to creep up (and the price of bonds continues to fall) it could be another sign of a return to more normal interest rates which, in Australia’s case, are when mortgages are priced at 7 per cent and not the current crisis level of less than 5 per cent.

Events on the bond market are trendsetters, which is why seasoned professional investors are today watching bond prices more closely than share prices (with the Australian 10-year bond price the template against which share prices are measured).

One recent calculation shows that a 10-year bond rate of 2.7 per cent corresponds to the All Ordinaries Index at around 5,500 (250 points less than where it is today), because as bond yields rise, the price of the blue-chip stocks that dominate the index will fall.

There are other factors at work in the market, including the commodity prices and consumer confidence, but the biggest influence on the stock market is the return investors can get from alternative, safe, investments.

Falling interest rates on fixed interest products such as bonds has been a big factor propelling Australian banks to record levels over the past few years, thanks to an investment strategy of buying bank shares rather than depositing money in the bank.

If that strategy changes, which it eventually will, bank shares will fall – which they have been doing for the past few days.

Unknown at this stage is whether financial markets are passing through one of their routine corrections, as assets are repriced to account for a very modest increase in the interest rate on bonds.

However, if the ‘normalisation’ trend continues in the bond market, then prices in every other market will also be normalised – painfully.