In our previous post, we discussed the potential impact that a falling interest rate environment falling interest rate environment may have on AT1 hybrids valuations. To summarize that article, BondAdviser does not believe an RBA cash rate cut will have too dramatic an impact on hybrid valuations. Further to this discussion, it feels prudent to explore movements in the bank bill swap (BBSW) rate in greater detail, particularly given its potential idiosyncratic nature in relation to the wider interest rate environment. As a simple background, the BBSW is the rate banks charge to lend money to one another. In the event of an overnight cash shortfall a bank can (and usually does) borrow from another bank at rates very close to the RBA cash rate. However, if the duration for such a loan is longer, meaning a period typically between 1 and 6 months, money is borrowed at a Prime Bank rate (set in Australia communally by the Big 4). The BBSW is currently referenced widely in derivative markets, and its use can function as a natural hedge to interest rate risk. Given BBSW is so widely used by banks and debt/corporate markets, movements in BBSW have wide reaching ramifications, including funding cost affects, which can then influence lending rates at a more grass roots level. As of 2017, after some ‘issues’ with transparency, the ASX took control of administering these interbank rates. There are formal short-term bank paper rates for each monthly tenor of between one month and six months. A majority of the AT1 hybrid market valuations are derived using the three-month BBSW, which has seen some important and possibly impactful movements in the first quarter of 2019. Over the first 11 weeks of 2019, the three-month BBSW has fallen 0.23 percentage points, or 23 basis points, to 1.85 per cent. This is in defiance of most predictions that the rise in bank wholesale funding costs would cause the BBSW to continue on the upward path in commenced and persisted with throughout 2018 (the BBSW rose 18 basis points through November-December 2018). Figure 1. BBSW3M Source: BondAdviser, Bloomberg Importantly, and somewhat obviously, these movements have occurred with zero movement in the RBA cash rate. Evidently, the movements of the BBSW are a reflection of various other contributing factors, some of which we will discuss here. As a starting point, Australian banks raise at least part of their funding requirements from offshore markets, a large portion of which are denominated in US dollars. The cross-currency basis has softened slightly throughout early 2019, with US and Australian interest rates expected to move in opposite directions. Juxtaposed against sentiments found widely throughout most of last year, this earlier display of AUD strength has relieved some operating pains for banks. Further, the much-discussed domestic housing market slowdown has caused some stagnation in lending. Whilst this relieves liquidity pressure, the reduced demand for credit is mirrored in part within BBSW rates, which is at least a partial reflection of an economy that is concerned about market direction and demand for funding. Noting both of the above points, additional insight may be obtained from movements in the Overnight Indexed Swap (OIS) rate, which is derived from the benchmark cash rate. A reduction in the BBSW-OIS spread from the historic highs seen toward the end of 2018 is evident in the below charts. Figure 2. Bank Bill Swap-Overnight Indexed Swap Spread Source: BondAdviser, Bloomberg The divergence between BBSW and OIS spreads could clearly be linked, among other things, to future cash rate expectations. Whilst the BBSW remains at higher than normal levels, this current trajectory can be interpreted as further evidence of markets softening, and the premium factored into the BBSW due to factors solely outside the cash rate being reduced. Many had speculated that higher funding costs have now become a structural feature of Australian markets; evidently inter-bank borrowing costs are more flexible that wider perception had believed. Interestingly, any upward pressure on the BBSW is usually exacerbated at the end of each quarter when banks look to lock in three-month funding. In the current case, such a trend cannot be readily observed, likely due to the factors discussed above, combined with the possibility (expectation) of a cut to the cash rate. It feels apparent that the banks will happily allow the BBSW continue to fall, provided profits are protected and funding costs are met. The impact this will have on AT1 hybrid valuations, which reference BBSW rates would be somewhat adverse. As some solace for AT1 hybrid investors, it is clear there is a disconnect between movements in the RBA target cash rate and the BBSW. Should the projected cuts occur to the target cash rate, hybrid investors may see relative value in the event that the BBSW does not decline as much as the rate cut, if it falls at all.