In the most simplistic terms, the banking sector’s profit increases when the fed hikes the interest rates. All retail banks, commercial banks, investment banks, insurance companies and brokerages tend to benefit as they have cash in hand because of customer balances and business activities. The increase of interest rates leads to an increase in the yield on the cash.
However, higher US interest rates affect big ASX banks like Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC) and National Australia Bank Ltd (ASX: NAB) because of the reason that these big banks, at the time of requirement, borrow huge amounts from the US which can increase the cost of funds. The current hike in interest rates also symbolizes that the US economy is improving and this impacts dollar values.
To understand better, a bank in Australia might borrow money from the US at a 2% interest rate, then lend that money to a buyer at 4% interest rate, earning a spread of 2% on this loan. After taking into account all the costs, most of the larger Australian Banks earn a net interest margin i.e. the spread of around 2%. Now, obviously if the borrowing rate is increased this reduces the spread for the Australian banks which directly impacts the Banks’ earnings unless they also make some changes at their end. If there is a hike in interest rates, Australian banks’ net interest margin can fall unless they revise the rates to borrowers and on mortgages.
The increases in the Fed’s 2019 and 2020 interest rate projections, in the range of 20bps and 30bps, suggest a more hawkish tilt to monetary policy than was previously expected. Bearing in mind the Fed’s latest rate decision and the amendments to its funds rate, growth and unemployment projections, there is an increased forecast for 2019 under a total of three hikes, with the funds rate ending the year at 2.75-3.00%. This new 2019 forecast is in line with the Fed’s overall target, but that will mark the end of the hiking cycle, and might remain lower for end of 2020 (to be just above 2.75% with funds rate median still over 3%).
Because of the hike in the Australian short-term interest rate benchmark the local banks are worried. When US gives a hike in interest rates, Australian banks take a backseat towards the local markets so as to meet their short-term needs. However, the Reserve Bank of Australia has retained its cash rate to 1.5 percent since mid of 2016. Australian rates are at record lows and Australian banks are swelled on the funding costs front, while Royal Commission has also downplayed the scenario for the banks.
Australian bankers have taken a note of bank bill swap rate (BBSW) which concurs with the new method of calculating the interest rate benchmark coming into picture after the royal commission in late May, following the scandal of the rate manipulation by banks. Dr. Shane Oliver, head of AMP’s investment strategy said that the puncture in the BBSW before the end of financial year could reflect Australian borrowers rushing to close in the funding in fear of worsening borrowing situation. Overall, it will be crucial to see how the ASX banks (ASX: WBC, ASX: NAB, etc.) modulate their strategy to keep up with financial sector pace.
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