SMSF Investing Education & Strategies

How do changes to the cash rate impact bond prices

by Elizabeth Moran
FIIG Securities.

The official cash rate is established by the Reserve Bank of Australia (RBA) at its monthly meetings. It helps to determines the overnight cash rate applicable to loans between financial intermediaries and is the main tool the RBA employs to dictate monetary policy.

What is the official cash rate ?

The current official cash rate (cash rate) is 4.75%, historically lower than the average over the last twenty years (see the diagram below).

 

Key to the RBA board’s decision-making process is the board’s goal of keeping inflation within the 2-3% range. Any significant changes in inflation have a flow on impact to expectations of the cash rate. For this reason analysts and economists pay particular attention to any new economic data released by the Australian Bureau of Statistics and press releases from the RBA about what influenced the board in making the monthly decision on the cash rate.

 

The RBA meets on the first Tuesday of the month, then announces the cash rate at on the same day at 1.30pm EST.

 

 

Changes to the cash rate do impact the bond market. However, the changes impact different types of bonds in different ways.

1. Floating rate notes

The coupon for floating rate notes (FRNs) is linked to an underlying benchmark and in most cases Australian bonds are linked to the bank bill swap rate (BBSW). BBSW is defined by the Australian Financial Markets Association (AFMA) as follows:

‘BBSW’ is the rate for a reset date will be the average mid rate, for Australian Dollar bills of exchange, accepted by an approved bank, having a tenor with a designated maturity, that appears on an approved information vendors service (eg. Thomson Reuters Screen BBSW page) at approximately 10.08am AEST, on the reset date (AFMA website).

 

BBSW takes into account the current official cash rate but also the expectations of future cash rate settings for each of the various contributors. If for example the banks expect cash rates to increase in the next three months, then 3 month BBSW will be higher than the cash rate to reflect that expectation. In effect it’s already built into BBSW. In Figure 2 below, as at 9 June 2011, monthly BBSW increases over the next 12 months, reflecting the market’s perception that the official cash rate will rise over that period. Interestingly, 12 month BBSW is less than 5.2%, so that the market thinks there will one cash rate increase in that period, but isn’t convinced there will be two.

 

FRN’s coupons are reset quarterly, and because banks typically take a three month view when assessing BBSW, expected increases or decreases to the cash rate will already be taken into account.

 

 

2. Fixed rate bonds

Fixed rate bonds can only show changes in interest rates through changes to the bond price (click here to view related educational article). A fundamental fixed income rule is the inverse relationship between fixed rate bond prices and yield. A decrease in yield will mean higher bond prices, so if an investor thinks that the official cash rate is going down, they would buy fixed rate bonds, expecting the price of the bonds to increase.

3. Inflation linked bonds

The relationship between bond prices and yield also holds true for inflation linked bonds.

If inflationary expectations are rapidly changing, given the economy is either booming, or going into recession, then inflation linked bonds will reflect those expectations.

 

- On the one hand, when the economy is booming, and inflationary expectations are moving rapidly upwards, then ILBs will rise in yield, and prices will fall.

- On the other hand, when the economy is rapidly moving into a recession, and inflationary expectations are moving quickly down, then ILBs will fall in yield, and prices will rise.

If the economy is broadly moving sideways, as it currently is, then the question of ILBs rising, or falling in yield depends on whether monetary policy is “tight” or “easy”.

 

- On the one hand, if monetary policy is “easy”, as reflected in the positive slope of the yield curve, where ten year bond yields are much higher than three year bond yields, ILBs will tend to rise in yield, all else being equal. This is generally because “easy” policy makes market participants expect higher inflation.

- On the other hand, if monetary policy is “tight”, as reflected in the flat, or negative slope of the yield curve, where ten year bond yields are much the same, or lower in yield than three year bond, ILBs will tend to fall in yield, all else being equal. This is generally because “tight” policy makes market participants expect constant, or lower inflation.

RBA policy is currently “mildly” tight, and is set to get tighter in the next twelve months. Much of the bond market reflects participants’ expectations, just like the share market. However, the expectations are not always accurate; the RBA can “shock” the market with an unanticipated change.

 

Elizabeth Moran
Director – Education and Fixed Income Research - FIIG Securities.

 

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