Statement on Monetary Policy – November 2006 Domestic Financial Markets and Conditions

Interest rates and equity prices

Money and bond yields

From the time of the August tightening of monetary policy, financial markets generally held the view that it was more likely than not that official interest rates would be increased again. In line with this, short-term market yields traded a little above the cash rate of 6 per cent for most of the period (Graph 47). During October, however, expectations of monetary tightening became more pronounced, particularly after the CPI data were released. By the end of the month, a tightening at the November Board meeting was fully factored into market pricing. The subsequent announcement of an increase in the cash rate to 6.25 per cent had little further impact on financial markets.

Yields on long-term bonds have followed a more varied path, falling initially – in line with US yields – but rising from mid October, again partly due to the rise in US yields (Graph 48). However, the recent rise in Australian yields has been more pronounced. As a result, the differential between Australian and US 10-year bond yields is now around 100 basis points, its highest level since October last year.

Despite the recent increases in bond yields, the Australian yield curve has remained more inverted than at any time since late 2000 (Graph 49). An inverted yield curve has, on some past occasions, foreshadowed a period of slower economic growth, moderating inflation and an easing in monetary policy. But the significance of a negative yield curve appears to have become less clear in recent years, as long-term bond yields have been held down by structural forces affecting global markets. The Australian yield curve has been inverted for much of the past two years, a period during which the market has typically not expected any easing in monetary policy.

Spreads on corporate bonds have widened a little since their trough in mid year but remain at low levels. Lower-rated bonds have seen the most movement, with spreads on A and BBB-rated bonds currently about 10 basis points higher than around mid year (Graph 50). Spreads on lower-rated debt issued by some non-financial corporates have widened as a result of recent merger and acquisition activity – both actual and anticipated. This is because the potential gearing up of these firms would increase debt-servicing burdens and hence the possibility of default.

Intermediaries' interest rates

Following the 25 basis point increase in the cash rate in early August, most lenders raised their variable indicator rates on housing loans by a similar amount. As was the case following the policy tightening in May, these increases were mostly passed on to existing borrowers within a week of the announcement. Between then and early November, most intermediaries' variable housing indicator rates were unchanged, with the exception of a few reductions by smaller lenders. At the time of writing, most lenders were yet to raise rates in response to the November tightening.

During the current tightening cycle, which began in May 2002, the target cash rate has been increased by 25 basis points on eight occasions, making a cumulative increase of 200 basis points. Assuming full pass-through of the November tightening, the major banks' standard variable indicator rate will have increased by the same amount over this period, but actual rates paid by new borrowers will have risen by a little less than 180 basis points. In part this is due to some non-banks offering housing loans with indicator rates lower than those offered by the major banks, and also some borrowers choosing to take out cheaper, basic loans. Mostly, however, it reflects borrowers' ability to obtain loans from banks at rates well below their indicator rates. The combined effect is that the average borrower now pays around 60 basis points less than the majors' standard rate, compared with 35 basis points less in early 2002.

Consistent with this, actual mortgage rates will be about 80 basis points higher than their decade average (assuming full pass-through of the recent tightenings), despite the cash rate being 100 basis points above its average (Table 11). That said, the fact that the current tightening cycle has been relatively long, and that housing credit has grown strongly over much of this period, means a relatively high proportion of current borrowers are paying a higher rate on their mortgage than when they took it out.

Rates on fixed-rate housing loans have been broadly unchanged since the time of the August tightening, in line with the cost of funding fixed-rate loans having been relatively steady (Graph 51). The major banks' average 3-year fixed housing rate is around 7.25 per cent. In recent months this rate has been at a similar level to the average actual rate on variable-rate loans. In August and September (the latest data available) almost 20 per cent of new owner-occupier housing loans extended were at fixed rates – the highest share since 1998.

Following the August (and May) tightening, most lenders also increased the interest rates on their personal loans and standard credit cards. Once again, however, increased competition in the market for ‘low-rate/no-frills’ cards saw a few providers delay increasing their rates on these cards until early October and, even then, not pass on the full increase in the cash rate.

With regard to business rates, intermediaries increased their indicator rates on variable-rate loans by 25 basis points following the August tightening, as was the case following the cash rate increase in May. However, competitive pressures in the business loan market in recent years have meant that the weighted-average rate actually paid on variable-rate business loans – incorporating risk margins – is still a little below its decade average (Table 11). Over the past few years, fixed rates actually paid on small business loans have tended to be lower than their variable-rate counterparts.

Interest rates on most online savings accounts rose by 25 basis points after the August tightening, reflecting the strong competition in this market, but rates on the majors' regular interest-bearing deposits rose by less.

Equity markets

The Australian share market has risen strongly over recent months, and has now more than retraced all of the decline experienced in the middle of the year. The ASX 200 index is currently 15 per cent higher than at the beginning of the year, similar to the gains in overseas share markets over this period (Graph 52).

Some of the recent strength in the share market has been driven by announcements of, and speculation about, merger and acquisition (M&A) activity. While some of these individual transactions have been large, in aggregate the number and value of deals actually finalised in recent months has not been particularly big in comparison with the past few years (Graph 53). However, several large M&A deals are pending. Moreover, the proportion of M&A activity that has been in the form of leveraged buy-outs (LBOs) by private equity funds has picked up significantly.

The available evidence suggests that the value of domestic LBO activity – including both the debt and equity funding – has increased to $13 billion so far this year, after averaging around $1½ billion over the past five years (Graph 54). In 2006 to date, LBOs by private equity firms have accounted for around 15 per cent of all corporate merger and acquisition activity where the bought-out company was an Australian entity. This compares with less than 5 per cent in previous years. Most of the pick-up has reflected an increase in the average deal size, with several deals in excess of $1 billion each. It is worth noting that, despite the increase in activity, LBOs in 2006 to date still account for less than 1 per cent of the value of the corporate sector as a whole. That said, LBOs typically result in a significant increase in the gearing of the bought-out company, potentially making it more sensitive to economic fluctuations. In recent years, for example, LBO deals in Australia have often resulted in the bought-out company having a debt-equity ratio several times higher than before the takeover. Companies which consider themselves under threat of an LBO may also gear up in defence.

For listed non-financial companies as a whole, the gearing ratio – the ratio of the book value of debt to equity – has increased in recent years, reversing the fall earlier in the decade (Graph 55). Despite this increase, the aggregate gearing ratio, at 64 per cent, remains a little below its long-run average.

It appears that the recent increase in the gearing ratio owes to an increase in leverage by companies that previously had low levels of gearing (Graph 56). Companies that had no debt in June 2004 have increased their gearing ratio by an average of 7 percentage points; those with gearing ratios from 1–25 per cent in 2004 have increased their leverage by an average of 12 percentage points. Importantly, companies that had gearing ratios above 50 per cent in 2004 have, on average, reduced their gearing over the past two years. Falls have tended to be particularly sharp for resource companies. Mostly, this reflects the strength of their profitability and retained earnings, which boosts equity in the company.

Recent profit results for ASX 200 companies with June and December year-ends have been strong, generally in line with analysts' expectations. Aggregate underlying profits (which exclude significant items such as write-downs and gains and losses from asset revaluations or asset sales) of these companies were 35 per cent higher than in the June half of 2005. This growth was again largely driven by the resources sector, which reported underlying profit growth of 72 per cent compared with the previous corresponding period. Profitability of other companies was more moderate, but still reasonably strong in most cases: financials reported underlying profit growth of 19 per cent in the latest half year, while companies outside of the resources and financial sectors reported underlying profit growth of 3 per cent, but 13 per cent if companies in the telecommunications sector are excluded.

Over the first half of 2006, analysts continually revised upwards their forecasts for resource company earnings per share in 2006/07, with expected annual growth revised from around 15 per cent to around 35 per cent, where it has since remained. The level of earnings in the following year is expected to be slightly higher. For non-resource companies, there has been a fairly consistent expectation that earnings growth for both the current and next financial years will be around 8 per cent. For resource and non-resource companies combined, earnings are expected to grow by around 15 per cent in 2006/07 and a further 6 per cent in 2007/08 (Graph 57).

Aggregate measures of equity market valuation have shown little change in 2006. The MSCI Australia trailing price-to-earnings (P/E) ratio is 16½, which is around its long-run historical average and also around the current P/E ratio for overseas equity markets (Graph 58). The Australian dividend yield has been around its post-1987 average of just below 4 per cent for most of the past few years.

Intermediated financing

After growing rapidly in the first half of the year, total credit has grown at a slightly more moderate rate in recent months (Table 12). The increase of 14 per cent over the past 12 months, however, remains high relative to the growth of nominal GDP. The recent slowing has been more marked for business credit, which earlier this year had recorded its fastest growth since the late 1980s. The slowing in business credit growth has been broadly in line with the moderation in aggregate business investment seen over the recent period.

After slowing through 2004, growth in lending for housing was broadly stable in 2005 and early 2006 before briefly picking up around the middle of the year (Graph 59). While special factors may have contributed to the up-tick around mid year, it should be noted that the subsequent easing is consistent with the cash rate increases in May and August having a modest dampening effect on demand for housing credit.

Personal credit has been growing more slowly than housing credit, increasing by 9½ per cent over the year to September. Within personal credit, growth in margin lending for the purchase of shares and managed funds moderated in the September quarter (Graph 60). Over the year, however, margin lending rose by 39 per cent, driven mainly by an increase in the average loan size, which rose to around $166,000.

Indicators of the riskiness of borrowers' margin loan positions, including the average gearing level and the proportion of available credit limits used, increased in the September quarter. In line with this and more frequent negative movements in share prices, the September quarter saw a small increase in the average frequency of margin calls. Despite these changes, these indicators of risk remain low by historical standards.

Non-intermediated financing

Bond raisings by Australian non-government entities reached a new high in the September quarter, with $53 billion of new bonds issued (Table 13). Around two-thirds of the debt was issued offshore, most of which was accounted for by financial institutions, although securitisation vehicles and non-financial corporations also had a strong quarter. This large volume of offshore issuance was supported by the prevailing levels of the cross-currency basis swap spread. The basis swap is part of the cost of borrowing in foreign currency and converting the loan to A$ and reflects the net demand to convert loans between A$ and foreign currency. It had been pushed down by a period of very strong A$ issuance by non-residents, who typically convert these raisings into foreign currency loans. This decline in the basis swap made it more attractive for domestic borrowers to issue bonds offshore in foreign currency and swap the proceeds into A$, rather than to issue directly in Australia; the subsequent issuance of such offshore bonds has moved these swap rates higher (Graph 61).

Outstandings of non-government bonds, both in the domestic and offshore markets, have grown very strongly for several years, with the latest quarter being no exception. There are now $300 billion of non-government bonds outstanding in the domestic market, with outstandings of asset-backed securities as great as the combined outstandings of the Commonwealth and State governments.

Total net capital raisings – debt, hybrids and equity – by financials and securitisation vehicles were very strong in the first three quarters of 2006 (Graph 62). For non-financials, net capital raisings picked up in the September quarter, following a couple of quarters that were relatively subdued.