International | Sep 18 2006
By Chris Shaw
Consensus in interest rate markets is the US has now ceased raising rates for 2006, a view shared by DBS. The bank now expects the market will focus attention on the potential for cuts to official rates, with such an outlook having implications for both yields and interest rate curve spreads.
With the market expecting cuts to interest rates there is, in DBS’s view, a likelihood the yield curve will actually invert in coming months, meaning there will be a lower yield on long-term debt instruments than for short-term instruments of the same quality.
But by how much the curve inverts is the key in its view, as that gives an insight into how far the market is expecting rates will come down in coming months. It estimates a spread between 3-month and 12-month securities of minus 50 basis points would indicate three or four rate cuts were expected in the next year, while a spread of minus 20 basis points suggests two rate cuts, the most likely outcome in DBS’s view.
Currently the curve is flat, which DBS suggests the market is taking to mean there will be one rate cut sometime in the next nine months. But with more cuts now being worked into expectations it sees the potential for LIBORs (London Inter-Bank Offered Rates), which is the rate at which banks lend unsecured funds to other banks, to fall, resulting in a curve spread of minus15 basis points by the end of the year.
Over the same time, it sees as likely a closing of the gap between the official Federal Reserve funds rate and the LIBOR rate, such that the three month LIBOR rate is likely to move below 5.25% by the end of the current quarter. DBS is forecasting both the three month and 12-month LIBOR rates to come down, at the short end by 30 basis points and at the longer end by 45 basis points, resulting in the 2-year swap rate hitting 5.0% from 5.26% currently.
Such changes in US rates would have implications elsewhere, as DBS notes for example the Hong Kong dollar is effectively pegged against the greenback and so any lowering of US rates implies lower Hong Kong dollar swap rates (a swap is an agreed exchange of cash flow positions, for example swapping a fixed rate loan for a floating rate loan).
DBS estimates the current 2-year swap rate of 4.3% will come down to around 4.15%, while the 10-year swap should fall to 4.5% from 4.6% currently. While similar downward pressure is likely on rates in Singapore the fall may be less pronounced, as DBS expects both the European and Japanese to lift interest rates further in coming months.
Despite this, it expects the 2-year swap rate will fall by around 30 basis points, while the 10-year swap is likely to come down by around 20 basis points during the current quarter. Once rate cuts begin in the US though DBS expects swap rates in the Singapore market will begin to rise quickly, with the 2-year swap moving to 3.5% in 1Q07 from 3.3% in this quarter and the 10-year to 3.75% from 3.5%.
