Statement on Monetary Policy – November 2007
Domestic Financial Markets and Conditions
Interest rates and equity prices
Money and bond yields
As described in the chapter on ‘International and Foreign Exchange Markets’, there was a significant tightening in global credit and money markets triggered by developments in the US sub-prime mortgage market. Short-term market interest rates in Australia rose substantially in the weeks following the last Statement. Through August and early September, as conditions in overseas markets tightened, local banks reported a significant rise in the cost of raising funds in offshore markets. In response, domestic banks began switching their offshore funding to domestic sources, which in turn helped push short-term domestic rates higher. By mid September, the 3-month Australian-dollar LIBOR interest rate, the benchmark rate for offshore funding, had risen to 7.2 per cent, 60 basis points higher than levels in late July, while yields on 3-month bank bills, a benchmark for domestic funding costs, had risen by around 45 basis points, to 7.1 per cent (Graph 55).
As conditions in global funding markets deteriorated from early August, the Reserve Bank experienced a sharp increase in demand for funding by domestic financial institutions in its daily open market operations. The Bank responded to the demand by providing additional liquidity to the cash market through these operations, in order to keep the cash rate as close as possible to the target set by the Bank’s Board which at the time was 6½ per cent (see ‘Box C: Reserve Bank Open Market Operations’). The extra liquidity provided by the Bank through its market operations contributed to an easing of concerns in domestic markets.
Short-term interest rates fell back in mid September as conditions in overseas credit markets began to improve. The decision by the US Federal Reserve on 18 September to ease monetary policy by a larger-than-expected 50 basis points proved to be a key factor underlying the improvement, though the attractiveness of yields also began to entice investors to return to the market. Many local financial institutions reported a steady improvement in their access to funding both onshore and offshore over the second half of September and throughout October. As conditions improved, the Bank withdrew liquidity from the cash market in line with reduced demand.
Short-term rates moved higher again in October, though this time it was not because of credit developments but rather expectations of a change in monetary policy as concerns about the turbulence on global markets gave way to renewed focus on the strength of the domestic economy. The release of the September quarter CPI saw these expectations intensify, so that by late October the market had fully priced in a 25 basis point tightening at the November meeting and an additional 25 basis point tightening to 7 per cent next year. The rates on 3-month Australian dollar LIBOR and 3-month bank bills are now around 7.1 per cent. Both rates are around 20–25 basis points above the corresponding overnight indexed swap (OIS) rate, compared with an average of about 6 to 8 basis points that had prevailed over the first half of 2007. The wider spreads are a reflection of the market’s reassessment of the risks underlying short-term funding transactions, though the spreads in the Australian market have remained below those seen in other major financial markets (Graph 56).
In contrast to the movement in global bond yields, domestic long-term interest rates have risen since the release of the last Statement (Graph 57). In August, yields on domestic government bonds declined slightly as US bond yields fell, with the domestic yield reaching a low of 5.8 per cent. Since then, yields have generally moved higher as conditions in global markets improved and with the release of data indicating the strength in the domestic economy. Reflecting their divergent movements and the relative strength of the two economies, the Australia/US 10-year spread has risen from around 120 basis points at the time of the last Statement to around 185 basis points, its highest level since late 2002.
The heightened credit market volatility has had a greater effect on perceptions of credit risk for financial institutions than for the rest of the corporate sector, with premia on credit default swaps (CDS) – financial derivatives that provide insurance against defaults on debt – for local banks increasing more sharply than for corporates in August and September (Graph 58). CDS premia for corporates have eased in recent weeks and are little changed from levels seen at the time of the last Statement (Graph 59). Premia for Australian banks remain elevated, but are notably below those for comparable US and European banks.
As has been the case overseas, conduits in Australia issuing asset-backed commercial paper (ABCP) have been among the entities most affected by the recent volatility in credit markets. Around two-thirds of the collateral backing Australian ABCP is residential mortgages, though this only accounts for just under 4 per cent of the value of Australian housing loans.1 In August, domestic conduits shifted much of their ABCP funding onshore, in response to the more difficult conditions offshore: data from Standard and Poor’s (S&P) indicate that ABCP outstanding onshore increased $8 billion (20 per cent), while offshore the amount outstanding fell $10 billion (31 per cent) (Graph 60). Overall, Australian ABCP outstanding – issued both onshore and offshore – fell by 3 per cent in August, compared to a decline of 20 per cent for US ABCP. Some Australian conduits called on their liquidity providers, although it appears that liquidity providers largely purchased ABCP rather than extending a loan. Partial data suggest that some funding continued to be switched onshore in September, with the level outstanding onshore rising 3 per cent. Conditions appear to have improved somewhat in October; a non-conforming lender has issued a new $400 million ABCP program, the first new program to be set up since the turmoil in markets began. Liaison with market participants suggests that spreads on ABCP picked up sharply in August, as in the US, to be around 30–40 basis points above the bank bill rate, relative to 2–5 basis points over recent years. Spreads have subsequently fallen back a little.
Reflecting the turbulence in offshore markets, domestic banks raised a slightly higher than usual share of their funding in local capital markets (see ‘Box D: Banks’ Funding’). While bond issuance by banks was relatively low in August, it picked up to be above average by October, albeit at higher spreads than earlier in the year. The issuance by banks has accounted for the bulk of bond issuance since end July (Graph 61).
Private bond placements – for which details are often not publicly available – appear to be higher than usual. Reportedly, only half of the residential mortgage-backed securities (RMBS) that investors are reviewing are public issues. For those bonds that have been issued, the spread to the swap rate has been wider than in recent years. Major banks have issued bonds in the domestic market at spreads of around 30 and 40 basis points for 3- and 5-year bonds respectively, compared with average spreads over the past year of around 10 and 15 basis points (Graph 62).
The longer-term securitisation market in Australia was also affected by the strains in global financial markets, with no RMBS issuance taking place in August. Since reopening in September with two RMBS issues coming to market, it has continued to recover. There were seven RMBS priced in October. The RMBS issues have been undertaken by both banks and mortgage originators. The deals have tended to be small, though there are signs that investor demand may be strengthening with the size of several recent issues being increased prior to their completion. However, spreads on RMBS have widened substantially from the low levels in recent years, and are around levels last seen in 2003 (Graph 63).
S&P placed PMI – a provider of lenders’ mortgage insurance (LMI) to around 45 per cent of securitised Australian housing loans – on negative credit watch, after the US parent company announced larger-than-expected losses in the third quarter. S&P has put the subordinated AA-rated tranches of around 200 Australian prime RMBS on negative credit watch, as typically the subordinated tranche of a prime RMBS is rated the same as the lowest-rated insurer of loans in the RMBS. While this affects around three-quarters of outstanding RMBS, the subordinated tranche only makes up a few percentage points of the value of an RMBS. The AAA ratings on the senior tranches have been affirmed as there is sufficient subordination to support the high rating.
Default rates on all domestic issues remain low. The last (rated) corporate bond default in Australia was mid 2004. In early October, Moody’s issued a report stating that the recent credit crunch has had no immediate impact on the stable rating outlook of Australian banks.
Intermediaries’ interest rates
The 25 basis point increase in the cash rate in August has been fully passed on to borrowers, though at the time this Statement was finalised, the November increase in the cash rate had yet to flow through to borrowing rates.
The turbulence in capital markets over the past few months has increased the funding costs of financial intermediaries over and beyond the effect of the higher cash rate. On average, with spreads at current levels, it has caused intermediaries’ funding costs to rise by about 10–15 basis points. Institutions that rely heavily on capital markets to fund their lending (such as mortgage originators and some regional banks) have been more affected than the major banks, credit unions and building societies which have large deposit bases.
There has been limited pass-through of this increase in funding costs to prime full-doc loans, which account for over 90 per cent of outstanding housing loans. Banks’ variable housing loan rates have only increased in line with the August increase in the cash rate, rising by 25 basis points since the previous Statement to 7.65 per cent. However, reflecting the larger increase in their funding costs, mortgage originators’ rates have risen by around 35 basis points over the same period (Table 11).
Interest rate increases have been more common for riskier housing loans, reflecting the larger increase in the cost of funding these loans. For prime low-doc loans, which account for around 8 per cent of outstanding housing loans, the average variable rate of banks has risen by 35 basis points since July, 10 basis points more than the increase in the cash rate, with the smaller banks increasing rates by more than the larger banks. Mortgage originators’ average prime low-doc rate has risen by 43 basis points. Interest rates on non-conforming loans (1 per cent of outstanding housing loans) have risen by around 100 basis points. Several large non-conforming lenders have also tightened their lending standards and discontinued some of their lower margin loans.
The larger increases in interest rates on prime low-doc and non-conforming loans relative to prime full-doc loans over recent months reverses only part of the trend over the preceding few years. Between 2004 and 2006, the spread between interest rates on prime low-doc loans and prime full-doc loans declined from 100 basis points to 30 basis points (Graph 64). The spread on non-conforming housing loans declined by 120 basis points over the same period. The falling spreads reflected the low realised losses on these loans (relative to the interest premium that was being charged), and greater competition between lenders, particularly in the prime low-doc loan market. Even after the recent increases, spreads on prime low-doc loans are still low by historical standards.
The five largest banks’ average 3-year fixed rate on prime full-doc housing loans is currently 7.9 per cent, 20 basis points higher than at the time of the last Statement. Smaller banks’ and mortgage originators’ 3-year fixed rates have increased by 30–35 basis points, a little less than the rise in the 3‑year swap rate, the benchmark rate for funding these loans. The share of owner-occupier loans approved at fixed rates increased to 19 per cent in September (the latest month for which data are available), well above its decade average of 12 per cent. Interest rates on personal loans are generally 30–40 basis points higher than at the time of the last Statement.
Large businesses have experienced significant pass-through of the increase in wholesale funding costs. These higher interest rates reflect the effects of the August monetary policy tightening, expectations of the November rate rise and future cash rate rises, and the increase in spreads resulting from the recent market turbulence. Around 45 per cent of large business loans (loans greater than $2 million) are directly priced off bank bills, and interest rates on these loans are estimated to have risen by about 15 basis points in August and a further 30 basis points over the next two months (Table 12). Another 40 per cent of large loans are at variable rates, and a sizeable proportion of these are also priced off bank bills, rather than the cash rate. Rates on these loans are estimated to have increased by a cumulative 35 basis points over the past three months. Large businesses also source about 20 per cent of their debt funding from capital markets, where variable rate debt is typically priced off bank bills.
Small businesses have been less affected than large businesses. About 50 per cent of small business loans (loans less than $2 million) are at variable rates, and at the time this Statement was finalised the five largest banks’ indicator rates had increased by 25 basis points since end July, in line with the August increase in the cash rate. Another quarter of loans are at fixed rates, and because only new loans are affected by the recent market turbulence, the weighted-average interest rate on the stock of outstanding loans has increased by less than the cash rate. The interest rates on loans priced off bank bills have risen more significantly; these loans account for around one-quarter of small businesses’ lending.
Prior to the November increase in the cash rate, financial institutions’ interest rates on online savings accounts, cash management accounts and bonus saver accounts had risen by 15–30 basis points since the last Statement.
Credit growth has remained strong over recent months with total credit expanding by 16 per cent over the year to September – its fastest pace of growth since the late 1980s (Table 13, Graph 65). Lending to businesses has grown particularly rapidly while there have been some signs of moderation in household credit growth.
Housing credit growth has moderated in recent months (Graph 66). This is likely to be a reflection of the August cash rate rise, as well as recent developments in credit markets. While volatility resulting from a spike in borrowing in June ahead of the superannuation rule changes may have affected recent figures, housing credit growth appears to have settled at about 0.8 per cent per month in August and September compared with the rates of around 1 per cent per month earlier in the year.
The outstanding stock of personal credit has fallen slightly over recent months following a sharp increase in June which was reportedly driven largely by households borrowing to invest in superannuation. While subdued growth over recent months is likely to reflect some unwinding of this effect, a 1 per cent decrease in margin lending over the September quarter has also contributed to slower personal credit growth.2 The decline in margin loan outstandings was driven by a 4 per cent fall in the average loan size, with many borrowers choosing to meet their August margin calls by paying down their loans. The high level of equity market volatility in August caused the number of margin calls per day per 1,000 clients to rise sharply to 1.04 in the September quarter, the highest level since December 2004. Despite the increase, the frequency of margin calls is still low by historical standards, largely due to borrowers’ low average gearing levels.
Total business debt increased by almost 20 per cent over the year to September 2007, the fastest growth since the late 1980s. Within the total, intermediated credit has grown very strongly, possibly reflecting some return to intermediation following the recent difficulties in credit markets (Graph 67). Much of the strength in business credit reflects robust growth in large loans (greater than $2 million), although growth in small loans has also accelerated recently. Part of the growth in large loans can be attributed to strength in syndicated lending, which is estimated to have increased by about 45 per cent over the year to September 2007. A large proportion of recent syndicated lending has been funded by the Australian subsidiaries of foreign banks. Syndicated loans have been mainly used to fund merger and acquisition (M&A) activity, though there has also been a pick-up in lending for general corporate purposes and capital expenditure. Companies in the finance & insurance and mining sectors have recorded the strongest growth in borrowing.
The non-intermediated debt market has not been as strong. Corporates had some difficulty rolling over their short-term commercial paper in August and September; short-term onshore debt outstanding fell by 20 per cent in both August and September. There were some signs of improvement in October, although outstandings remain well below the level at end July. There have only been a couple of non-financial corporate bond issues since mid July. Corporate bonds outstanding fell 4½ per cent between end July and end October.
Following strong raisings in July, net equity raisings slowed in August amid the volatility in global equity markets. However, in September and October net equity raisings have returned to more normal levels.
Equity markets have been volatile in recent months. The ASX 200 fell 12 per cent from its peak in July to its low in mid August. Since then it has more than regained these losses, reaching a new high in November. Over the year so far, the ASX 200 is up 18 per cent compared to a 4 per cent increase in the S&P 500, and a 4 per cent increase in the MSCI World excluding US (Graph 68).
The out-performance of the domestic market reflects the strength of the resources sector and the better performance of the share prices of Australian financial institutions (Graph 69). The share prices of Australian banks followed US banks lower in August amid the initial credit market developments and on concerns that widening credit spreads may affect funding costs. In contrast to US banks, which have issued weak earnings reports related to losses in credit markets, prices for Australian banks have recovered since then (Graph 70). The major Australian banks have almost no exposure to US sub-prime mortgages and rely less on proprietary trading for their profits. Banks’ underlying profits rose strongly over the past year, reflecting solid growth in net interest income and non-interest income (wealth management, insurance, trading and fee income) and limited cost increases.
Share prices of Australian companies generally have been supported by relatively strong profit results. Almost two-thirds of ASX companies that reported recently announced an increase in underlying profits (which exclude significant items and asset revaluations/sales). In aggregate, underlying profits after interest and tax were 9 per cent higher than in the corresponding period of 2006. Growth was underpinned by the financial and non-resource sectors. Resource companies’ profits were broadly unchanged, as the high level of commodity prices and increased output offset higher labour costs and infrastructure constraints. Nonetheless, resource companies’ profits are at a very high level following average growth of around 60 per cent in recent years. Overall, profit results were generally in line with expectations.
Earnings expectations were little changed following the profit reporting season, but more recently analysts have revised their earnings forecasts for non-financial companies. Analysts continue to expect earnings growth for resource companies to slow from almost 30 per cent in 2006/07 to 5 per cent in 2007/08, though they now expect growth to pick up again to 19 per cent the following year. Financials’ and other companies’ growth forecasts remain steady for the next few years, ranging between 8 and 10 per cent. Analysts lowered their earnings forecasts for other non-financial companies in 2007/08 to 4 per cent partly due to concerns about US demand, but continue to forecast 11 per cent growth the following year.
The most recent increase in share prices has been broadly matched by profit growth. As a consequence, the P/E ratio is still around the levels of the past six months, which is a few points above its long-run average. The dividend yield currently stands at 3.4 per cent, a little below its long-run average of 3.8 per cent.
Despite the volatility in markets, M&A activity has remained strong (Graph 71). M&A activity has been broad-based across different sectors. Currently almost $45 billion of deals are pending. Several large takeovers were completed in recent months.
- For more details refer to ‘Box A: The Australian Asset-Backed Commercial Paper Market’, RBA Financial Stability Review, September 2007, pp 32–35.
- Some margin loans are made to businesses and trusts, and hence are captured in business credit rather than personal credit.