Why rates will head higher

The Reserve Bank has left interest rates on hold, and this week I have four interesting charts that I believe give an insight into the direction of rates in 2014.

At the very least, they will expose the perversion of international bond markets, the requirement for more central bank intervention, and the risk of inflation that emanates from China.

The first chart (Figure 1) is a forecast of the financing needs of the major economies in the Eurozone over the next two years. Financing needs can be described as the amount of bonds that a government will need to issue to meet maturing debt and expected fiscal deficits. Clearly Italy, which is Europe’s third-largest economy, has a mountain of debt to refinance. At 55% of GDP, this is probably beyond the capacity of capital markets to negotiate and so European Central Bank (ECB) assistance is required.

To understand the level of bond issuance, think of it in Australian economic terms. If Australia was Italy, then we would be issuing and negotiating about $850 billion of government debt over the next two years. Of this, about $200 billion would be deficit funding and $650 billion would be maturing debt.

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Figure 1 shows that Greece, Portugal, Spain, Belgium and France also have significant debt negotiations in coming years. Each member of the Eurozone continues to run high fiscal deficits with low economic growth rates and high unemployment (average of 12%).

What is indeed strange and illogical from the above observations is the next chart (Figure 2). It shows the extraordinary rally in sub-prime European bonds. How could it be that countries with large government debt loads of about 100% to GDP and large refinancing commitments benefit from lower bond yields? Further, how could Italian, Irish and Spanish 10-year bonds yield below those of Australia? Is our AAA credit rating worth anything?

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The Eurobond markets are operating in a perverse manner,, similar to what they did prior to the GFC. In 2007 Eurobond managers struggled to differentiate between a German and a Greek bond, with just 0.5% yield sitting between them. The best capital managers in the world could not see the risk of a potential Greek default. Today one may well ask, is there a risk of an Italian default that is not priced into Italian bonds?

Figure 3 shows the massive growth in central bank balance sheets as a result of quantitative easing (QE). Notably the ECB balance sheet has declined in the last year as it has not undertaken QE but recycled bank deposits and loans across Europe.

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Indeed, the ECB decreed that it will provide unlimited finance to European banks to ensure the viability of the Eurozone. The underwriting of Euro banks effectively underwrites large European countries. European banks borrow from both the ECB and European households at large because credit growth outside the government sector is non-existent. Bank deposits are rising, and the cost of these is negligible. Therefore the purchasing of bonds by banks is an easy way to make margin or profit with “limited risk”. This is a wonderful position for banks that need to recapitalise.

However, the biggest risk for the banks and perversely the sub-prime governments is the re-emergence of European growth and therefore the general demand for credit – for this would surely drive up interest rates. Thankfully economic growth cannot be seen on the horizon and therefore bond yields are stuck at ridiculous levels. A feeling that governments are too big to fail permeates across Europe.

As for the direction of Australian bonds that have weakened dramatically in the last six months, it could well be the emergence of inflation from China that determines our fate.

To this point I draw on my final chart (Figure 4) that plots the methodical revaluation of the Chinese renminbi and the US dollar. This year we have witnessed a 3% revaluation of the Chinese currency and this translates into a 15% revaluation against the Australian dollar. Arguably the days of cheaper consumer imports from China are over as the $A devalues against the $US and therefore the renminbi.

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The last five years have been a wonderful period for Australian consumers as the terms of trade reached record levels.  However, this period is now over and, in coming years, Chinese imported inflation will replace the deflation that resulted from a grossly undervalued Chinese currency. Therefore a slowing economy and a weakening currency are in store for Australia in 2014.

The Reserve Bank is reticent to cut cash rates further, fearing the creation of investment asset bubbles that have been seen overseas. The risk of imported inflation is real and adds to the forecast of a sharp lift in energy prices.

Consequently interest rates settings are certainly stuck at current levels for the next six months. From that point a weakening currency may well see inflation emerge rapidly and require the RBA to change course. Indeed that is what the weakening Australian bond market is telling us: interest rates will rise in 2015.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Income Portfolio Statistics

Return since June 30, 2013: 9.83%

Returns since Inception (April 24, 2012): 37.98%

Average Yield: 7.27%

Start Value: $150,754.88

Current Value: $165,579.79

Dividends accrued since June 30, 2013: $4,394.92