HEAD OF TREASURY, EUROPE ARAB BANK
WHILE not necessarily as zealous as Ronald Ryan – the preface of his 1997 book Yield Curve Dynamics contains the immortal line “God bless the yield curve” – I happily and enthusiastically recommend that all investors, whatever their market, pay careful attention to the yield curve, its shape, its level and its changes over time. Worthy of studying in its own right, term structure modelling is one of the most heavily researched subjects in financial economics.
But this isn’t an academic column, so the poetry of the yield curve doesn’t concern us here. What insight can investors draw from the curve today? Well, interestingly, the euro interest-rate swap curve – which is a plot of the time structure of interest rate swap rates that represent bank borrowing rates today for different maturities – has not responded to the southern Eurozone debt crisis in the way that one might have expected.
One might have thought that the Eurozone sovereign debt crisis would, everything being equal, have had a negative impact on market rates and the interest-rate swap curve, thus leading to higher corporate borrowing costs. This is not illogical. If investors are worried about sovereign credit risk, it is natural to expect a flight-to-quality and a widening of swap spreads. A result of this would be higher debt servicing costs for corporates, which typically have their loan interest rates re-set every quarter to the Libor curve. This turns out not to be the case. Compared to the beginning of the year, just before the Greek debt crisis erupted, euro swap rates have fallen (three-year at 2.26 per cent on 10 January and at 1.84 per cent today; five-year rates at 2.79 per cent and 2.43 per cent respectively). As important, the spread to the government benchmark has also fallen, from 64 basis points (bps) to 47bps and from 38bps to 30 for the three-year and five-year respectively. So the panic has not spread to corporate borrowing rates.
The swap curve itself has steepened, the euro two to 10 year swap spread increasing from 171bps to 183 bps. As markets came round to the idea that central banks would not be raising rates for some time, yield curves have steepened this year. Banks have generated considerable gains from gapping the steep yield curve, lending long-dated and funding short-dated which, as Sherlock Holmes would say, is the settled natural order of things. However, banks that are structurally asset-sensitive will gain more than banks that are liability-sensitive once rates start rising. Yield curves will at some point flatten in anticipation of rate rises. So it becomes important for liability-sensitive banks to position themselves ahead of this anticipated change, the timing of which depends on when rates are expected to rise.
At least, that is the orthodox logic. The chart shows the UK gilt yield curves for March 2008 and March 2010. The steepening is self-evident. But while there is much precedent for yield curves to flatten as rates start rising, this has not always been the case – in 1994 when the US Federal Reserve started hiking, long-dated rates rose by more than short-dated ones. But this time, fundamentals suggest the curve should follow conventional principles.
To conclude then, investors and borrowers should base their decision-making on the fact that firstly, short-term rates are at historic lows and will stay low for the time being and secondly, once rates start rising, they will be on an upward spiral until they reach their peak perhaps two or three years later. The yield curve will continue to steepen as markets anticipate higher long-term rates in the future, but will then start flattening once central banks actually start hiking. Time to fix that mortgage interest rate now for five years or longer.
Moorad Choudhry is editor of the EAB Treasury Morning Shout www.eabplc.com