Reserve Bank of Australia anxious on Trump's borrowing binge

John Kehoe

Reserve Bank of Australia governor Philip Lowe errs on the side of caution when commenting on politics, so it was notable that he expressed veiled concerns about US President Donald Trump's policies in Tuesday's prepared statement on local monetary policy.

The politically astute Lowe, of course, did not explicitly mention Trump by name.

It would be an odds-on bet that the volatile President's international shockwaves from binge borrowing and China trade tensions were discussed behind closed doors at Sydney's Martin Place when RBA board members met this week and opted to hold the overnight cash rate steady at 1.5 per cent.

The best new insight from Lowe's statement was his noting of the "tightening of conditions in US dollar short-term money markets, with US dollar short-term interest rates increasing for reasons other than the increase in the federal funds rate".

"This has flowed through to higher short-term interest rates in a few other countries, including Australia."

I wrote on March 16 that central banks were closely watching the spike in the spread between the three-month US LIBOR and overnight indexed swap (OIS) and were conscious of ramifications for government and commercial bank funding around the world.

Triple T Consulting fixed income analyst Sean Keane says the RBA's inclusion of the issue was "significant".

"The RBA's decision to mention this issue would not have been taken lightly and it indicates that the funding pressure has the potential to affect lending and borrowing rates more broadly in the local economy," Keane wrote in a research note.

"The governor will certainly be asked about this on his next public outing."

Australia catches rate chill

Unorthodox US government policies are beginning to infect Australian market interest rates.

Suncorp's banking and wealth chief executive, David Carter, two weeks ago blamed the rise in the local three-month bank bill swap rate for his decision to edge higher the bank's home loan mortgage rate by 0.05 of a percentage point.

The US LIBOR-OIS spread (London Interbank Offered Rate and the Overnight Indexed Swap rate) has hit its highest level since the 2008 financial crisis, not just due to US Federal Reserve tightening.

Usually, a leap in the LIBOR-OIS spread is a sign of stress in the banking system, such as during the 2008-09 financial crisis and the 2012 euro zone debt crisis.

However, today Wall Street banks are widely considered healthy [by whom?] and fixed income traders believe the US government's short-term borrowing binge is partly to blame.

While there are myriad reasons for the leap in short-term US borrowing costs, major causes are: loose US fiscal policy; US tax changes that nudge technology and pharmaceutical multinationals to park less cash in bonds and repatriate $US2.6 trillion foreign profits; and unusual borrowing behaviour by the US Treasury.

The US Treasury will run a $US1 trillion budget deficit this year, equivalent to about 5 per cent of GDP, to finance debt-funded tax cuts and a profligate spending blowout by Republicans and Democrats in Congress.

Paradoxically, the extra debt issuance comes as the US Federal Reserve becomes a net seller of debt securities, as it begins to slowly unwind its $US4.5 trillion bond-buying stimulus.

Cheap debt blowout

Most problematically for short-term money markets, the US Treasury is issuing hoards of cheap debt with short maturities, pushing up interest rates at the short end of the yield curve.

To be sure, it is also selling some long-term 10-year bonds.

The usual practice by governments is to overwhelmingly fund deficits by locking in secure and stable long-term borrowing.

Indeed, RBA deputy governor Guy Debelle subtly pointed out the US was an outlier in a recent speech.

"One interesting exception to the general tendency to term out their debt is the US Treasury, which is undertaking a sizeable amount of issuance at the short end of the curve," Debelle said.

Essentially, Treasury Secretary Steven Mnuchin is tapping cheaper short-term money to fund long-term liabilities.

It is a bit like a real estate developer (Trump?) funding building projects on a credit card requiring monthly repayments of principal and interest.

The US Treasury's strategy to favour short-term debt over longer term bonds is risky because it leaves the US government exposed to rollover repricing risk, especially if US interest rates spike higher as some inflation hawks worry.

Mnuchin was a senior executive at Goldman Sachs' fixed-income business in the 1990s, so he is experienced in debt markets and presumably comfortable with the Treasury's funding model.

Nevertheless, it effectively means the US Treasury is partially "crowding out" other borrowers such as banks and pushing short-term funding costs higher. As a result, hedging costs for foreign borrowers are also rising.

A word with Mnuchin

Australian banks have taken a more prudent course since the 2008 global financial crisis, tapping long-term funding markets to cement low cost and reliable funding for three, five and 10 years.

But the RBA is still alert to the jump in short-term market funding costs.

Less surprising was that Lowe noted the recent volatility in equity markets was stoked "partly because of concerns about the direction of international trade policy in the United States".

The dangers for the Australian and world economies from Trump's potential US-China "trade war" (trade tension is probably the more accurate definition given the relatively minor tariffs announced so far) have been well telegraphed in recent weeks.

As it happens, either Lowe or Debelle will have an opportunity to discuss economic conditions with Mnuchin at the spring meetings of the Group of 20 and International Monetary Fund in Washington on April 16-22.