Statement on Monetary Policy – May 2006 Domestic Financial Markets and Conditions
Interest rates and equity prices
Money and bond yields
Short-term interest rates were fairly steady for most of the period since the last Statement, at a level consistent with a cash rate of 5.5 per cent. During April, however, they rose noticeably in response to a number of stronger domestic data releases, strengthening prospects for the world economy and rising commodity prices. By late April, the market had fully priced in a 25 basis points tightening within several months, with a greater than 50 per cent chance of it occurring in early May (Graph 45). In the event, when the Bank did tighten in May, yields rose only a little further.
Bond yields have also risen since the time of the last Statement, with 10-year government bonds now yielding around 5.80 per cent, an increase of 50 basis points over the period. The rise in bond yields has exceeded the rise in money market rates and the yield curve has moved from being inverted to being flat (Graph 46).
Despite having risen in recent months, yields on long-term bonds are not much higher than in early 2005. In contrast, US bond yields have risen by around 85 basis points since early 2005 (Graph 47). The bigger rise in US yields reflects the fact that monetary policy tightening in the US has turned out to be greater than expected by markets a year ago. As a result of the smaller increase in yields on Australian securities, the spread between Australian and US 10-year bond yields narrowed considerably, to around 55 basis points in late March/early April, its lowest level in five years. It is now around 65–70 basis points.
Yields on inflation-indexed bonds have also risen in recent months, with yields on 10-year indexed bonds currently 65 basis points above their lows recorded in January. The increase has been broadly in line with the increase in nominal bond yields over the same period, with implied inflation expectations remaining a little over 3 per cent. As discussed in the last Statement, institutional factors have boosted global, particularly European, demand for indexed bonds relative to conventional bonds, thereby holding down their yields and pushing up implied inflation expectations.
Spreads on corporate bonds – an indicator of financial market participants' perceptions of credit risk – are little changed since the time of the last Statement and remain low compared with recent years (Graph 48). Premia on credit default swaps, which are financial derivatives that provide insurance against losses from default on corporate bonds and loans, are also at low levels. The low credit spreads reflect a combination of generally good prospects for Australian companies – strong profit growth, low default rates and a favourable economic environment – and strong demand for corporate bonds from Australian and non-resident investors.
Intermediaries' interest rates
Most intermediaries' variable housing loan indicator rates have not changed since the time of the last Statement, with intermediaries yet to respond at the time of writing to the May monetary policy tightening. During the past three months, a few smaller lenders had reduced their indicator rates by around 10–20 basis points, but this was usually only for their honeymoon and basic variable-rate products. As has been the case for some time, most of the recent competition on housing loan interest rates has been reflected in increases in the size and availability of discounts being offered on indicator rates, rather than in changes in the indicator rates themselves.
A number of lenders in recent months have lowered the thresholds at which their housing loan interest rate discounts apply. Most now advertise a 70 basis point discount for loans between $250,000 and $500,000 whereas a year ago a 50 basis point discount was the norm for loans of this size. Also, it has become more common for borrowers, particularly those taking out bigger loans, to negotiate larger discounts than those that are advertised.
Reflecting the trend towards discounting, the effective rate that borrowers pay on new housing loans has been falling relative to housing loan indicator rates for some time. In mid 2005, the latest period for which we have reliable data, the average rate paid on new variable-rate housing loans was around 6.8 per cent, or ½ percentage point below the major banks' average standard variable indicator rate (Graph 49). This average discount has increased by around 30 basis points since early 2000, with the available evidence suggesting it has increased further over the past year.
Borrowers who receive a discount to the prevailing indicator rate are usually entitled to that discount for the life of the loan. In the event that bigger discounts subsequently become available, existing borrowers can obtain these by refinancing their loans. The fact that the average interest rate being paid on all outstanding housing loans is only a little above the average rate being paid on new loans (and that the refinancing share of loan approvals has risen in recent years) suggests housing loan borrowers have become keener ‘shoppers’ and are taking advantage of higher discounts (Graph 50). In part, this behaviour has been encouraged by the rise of mortgage brokers who are now estimated to arrange around one-third of housing loans.
With respect to fixed-rate housing loans, interest rates were relatively steady between late 2005 and mid April at which time they were raised in response to the pick-up in bond yields. Nonetheless, the major banks' average 3-year fixed rate, currently 6.85 per cent, is still broadly in line with the average of the past two years and the rate paid on standard variable-rate loans (after discounting). Demand for fixed-rate housing loans was relatively strong over the three months to February, the latest period for which we have data.
The competitive pressures in the housing loan market are also evident in the business loan market. The spread between the weighted-average variable rate paid by businesses and the cash rate continued to fall in the December quarter of 2005 and has declined by over 1¼ percentage points since early 2000. This narrowing of business loan spreads reflects the moderation in lending to households and the emergence of a number of regional and foreign-owned banks competing more aggressively for a share of the business lending market. Surveys conducted by JPMorgan and East & Partners indicate that loan discounting is occurring across all customer segments, from small to large businesses (Graph 51). As in the housing finance market, refinancing activity in the business loan market has been encouraged by the growing use of loan brokers.
Equity prices
Australian share prices have increased by 11 per cent so far in 2006, reaching new record highs (Graph 52). While the rise was particularly pronounced for resource companies, reflecting further large increases in commodity prices, all sectors apart from telecommunications recorded increases. The domestic share market has continued to outperform most major overseas equity markets.
Since its trough in March 2003, the Australian share market has recorded 12 consecutive quarters of positive returns, with prices almost doubling over the period. The last long rally in the share market (over 11 quarters from December 1984 to September 1987) ended with a 40 per cent fall in the December quarter of 1987 but that rally was considerably more speculative than the current one.
One indication of this can be gained by comparing movements in share prices and company profits for each period. Graph 53 does this for resource and other companies. The Australian share market was relatively flat in 2001 and 2002, with its rise since then mostly concentrated in the resources sector. But the rise of 175 per cent in this sector has been well supported by higher profits, with share prices running a little ahead of profits only recently. Other companies' share prices have risen by around 45 per cent, on average, with their profits rising by more. Consequently, the price/earnings (P/E) ratio for the market as a whole remains broadly in line with the March 2003 level and its post-1980 average. Moreover, the current dividend yield is only slightly below average.
In sharp contrast, the 1984–1987 rally saw the share prices of resources and other companies increase by almost 200 and 300 per cent, respectively, with neither of these gains supported by similar increases in earnings. Consequently the P/E ratio doubled to around 20 over the period, and dividend yields fell to very low levels. The 1984–1987 rally was also characterised by a surge in equity market turnover and sharp increases in corporate debt levels, neither of which has been evident during the current rally.
The latest corporate profit reporting season was another strong one. Underlying profits (which exclude significant items such as write-downs and gains and losses from asset revaluations or asset sales) for the half year to December 2005 amounted to $35 billion, 24 per cent higher than in the corresponding period of the previous year. Resource companies reported the strongest growth, with their aggregate underlying profits rising by 65 per cent, boosted by higher prices for base metals, bulk commodities and oil (Graph 54). The profit results were consistent with analysts' earnings expectations.
The strong growth in resource companies' profits since 2002 has seen their return on equity rise from 5 per cent to 25 per cent (Graph 55). Other non-financial companies have also increased their returns on equity, albeit more moderately.[1] Resource companies' strong profitability has contributed to a substantial decrease in their gearing levels: the debt-to-equity ratio has fallen to 25 per cent, from 55 per cent in 2002. This is despite some increase in these companies' debt levels over the past year, consistent with the increasing amounts of investment they have undertaken. In contrast, other non-financial companies' debt-to-equity ratios have remained fairly constant at around 60 per cent, reflecting similar increases in debt and equity levels.
The strong rise in share prices and increased investment in shares by households have resulted in a large increase in the value of household share holdings. These holdings are now equivalent to about 100 per cent of annual household gross disposable income, up from 20 per cent fifteen years ago (Graph 56). Around half of these shares are held directly and the remainder indirectly through superannuation funds, life insurance and other managed investments.[2]
This rise in the value of share holdings has underpinned a rapid accumulation of financial wealth by Australian households, even though the household saving rate, as conventionally measured, is very low. This apparent contradiction is examined in Box D. In essence, the conventional measure of household saving calculated from the national accounts systematically understates the extent of household saving in countries such as Australia where households tend to invest mainly in shares, since the return on shares that comes in the form of capital gain is not captured in such measures.
Financing activity
Intermediated financing
Total credit growth has picked up in recent months, with the six-month-ended annualised rate increasing to 15.2 per cent in March, the highest rate since early 2004 (Table 10 and Graph 57). While total credit growth continues to be underpinned by rapid growth in business credit, household credit also recently appears to be showing signs of strengthening. Growth in both the housing and personal components of household credit has picked up since the troughs of late last year, leaving the six-month-ended annualised growth rate of household credit at 13.8 per cent. This has coincided with a modest strengthening of conditions in the housing market and the aforementioned ongoing competition in lending markets that is placing downward pressure on interest rate margins.
Growth in business credit continues to gather pace, reaching a six-month-ended annualised growth rate of 17.7 per cent in March, to remain around the highest rate recorded since the late 1980s. Data on banks' business lending by size of facility indicate that the pick-up in the growth of total business credit over the past few years has mainly been due to stronger growth in ‘large’ loan facilities, defined as those over $2 million each. Consistent with this, data from the annual and interim reports of listed (non-financial) companies suggest that intermediated borrowing in 2005 by the top 350 companies was relatively strong.
Non-intermediated financing
Australian non-government entities issued a near record $46 billion of bonds in the March quarter of 2006 (Table 11). Of this, financial institutions issued $30 billion, roughly double their post-2001 quarterly average (Graph 58). Most of these bonds were issued in offshore markets, with strong investor demand and low cross-currency basis swap spreads allowing the major banks to issue large volumes in foreign currency and swap into Australian dollars at attractive interest rates. Asset-backed vehicles' bond issuance was also a little above average in the March quarter, but was fairly evenly divided between domestic and offshore markets. Non-financial corporates' bond issuance was weak.
In addition to the large issues by Australian entities, non-residents issued a record $20 billion of Australian-dollar denominated bonds in the March quarter, with heavy demand from Australian and non-resident investors allowing European and US financial institutions to issue large quantities of debt at low spreads. While this took place in a number of markets, issuance in the domestic market was particularly strong. Foreign quasi-government entities also made substantial issues in the domestic market.
With gross issuance far in excess of maturities, total outstandings of non-government bonds in the domestic market have continued to grow strongly. At the end of March, outstandings stood at $261 billion, compared with just over $50 billion each of Commonwealth and State government bonds (Graph 59). Non-residents accounted for two-thirds of the increase in non-government bonds in the past quarter, with the rapid growth in their outstandings over the past couple of years indicative of the strength of demand for high-quality Australian dollar securities.
Australian companies' net equity raisings amounted to only $4 billion in the March quarter. The weakness was partly seasonal and follows exceptionally strong raisings in the December quarter of 2005. In addition, and as noted above, financial institutions (who raised only half their usual amount) were very active in debt markets while non-financial companies have generated high levels of internal funds.
Footnotes
News Corp made a very large loss of $11 billion in 2002 and has been excluded from these calculations. [1]
Direct share ownership by Australian households is high by international standards: according to a survey by the Australian Stock Exchange, just under half of Australia's adult population own shares directly, similar to the US and Canada but more than double the proportion in Europe. [2]