Statement on Monetary Policy – August 2008
Domestic Financial Markets
Money market and bond yields
The funding pressures which emerged in global money markets in August 2007 have remained evident in the Australian market during the past three months, although they have not intensified. Three-month funding rates for banks are around 35 basis points above expectations for the cash rate, just below the average spread during the past year but much higher than in earlier years (Graph 45). Recently, bill rates have declined significantly as market participants have shifted their expectations of the future direction of monetary policy. In early June, the market was pricing in an additional tightening in monetary policy in 2008, but with mounting evidence that domestic demand is easing the market now expects two reductions in the cash rate in the coming months.
Long-term interest rates have declined since the last Statement (Graph 46). Generally, long-term yields have moved in line with global yields, but in the past month, domestic yields have fallen further, with the market now projecting that the cash rate has peaked. The spread between the Australian 10-year bond rate and that in the United States has narrowed by around 40 basis points. The spread between government bond and swap rates has also contracted as long-term rates have declined.
In May, the Australian Government announced that it would increase the outstanding amount of Commonwealth Government securities (CGS) on issue by $5 billion during 2008/09 – and by up to $25 billion over the coming years – in order to improve liquidity within the market. At the time, this announcement contributed to some narrowing in the spread between CGS yields and swap rates. The Government also announced its intention to remove interest withholding tax on state government paper issued onshore. This is likely to result in the consolidation of offshore and onshore lines issued by state authorities.
In its market operations recently, the Bank has generally maintained aggregate exchange settlement (ES) balances at around $1½–2 billion. This is a higher level than that which prevailed before the onset of market turmoil in August 2007. Anticipating that there may be funding pressures surrounding June quarter-end, the Bank increased ES balances to over $6 billion on 30 June, before reducing balances swiftly in the following days. These actions were successful in ensuring that the domestic cash market functioned smoothly and on all trading days since the last Statement the cash rate has traded at the target level set by the Board.
In line with international markets, the ASX 200 has experienced a substantial decline over the past three months. Since the peak in November last year, equities have fallen by 27 per cent, the largest fall in the past 20 years and one of the largest since the beginning of the 20th century (Graph 47, Table 11). The largest decline occurred between February 1973 and December 1974 when share prices halved. While movements in the ASX 200 have broadly tracked global equity markets, the local market has underperformed in 2008, falling by more than other major markets after rising by more in 2007. The equity market has also experienced considerable volatility since the onset of the credit turmoil, with daily movements averaging 1.2 per cent, around twice the size of average fluctuations in the past 20 years.
The decline in equity markets has been concentrated among financials and other non-resource stocks (Graph 48). The share prices of financial institutions have generally moved in line with those globally, despite the markedly stronger balance sheets of the Australian banks compared with many of their counterparts offshore. The announcements by a couple of the major Australian banks that they were increasing provisions saw prices fall heavily late in July. Since their peak in late last year, banks’ share prices have fallen by about 35 per cent.
Listed property trusts have also experienced substantial declines in their share prices which have fallen by 21 per cent since end April on earnings downgrades and continued concerns about leverage. Resource share prices held up relatively well over the past year, supported by strong commodity prices and speculation of foreign interest in investing in Australian mining companies. However, they too have fallen sharply in recent months, declining 24 per cent since their peak in mid May, as some commodity prices have come off their peaks.
Falls in share prices this year have contributed to negative returns for most superannuation funds. Australian superannuation funds had a median return of –8½ per cent over the 2007/08 financial year, the lowest annual return in at least two decades (Graph 49).
The decline in the share market has also led to falls in both the trailing P/E ratio (which is based on earnings for the past year) and forward P/E ratio (based on expected earnings for the next financial year) (Graph 50). Both remain well below their long-run averages, with ratios falling to levels last seen in the early 1990s. There continues to be divergence in valuations across sectors – financials’ trailing P/E ratio remains well below average, while resources’ P/E ratio is a little above average.
Analysts have generally revised down earnings expectations for the current year in line with weaker earnings guidance provided by some companies and the recent announcements by some of the major banks of increased provisions. Profits for the ASX 200 for 2007/08 – which will mostly be reported in August – are expected to be broadly flat, following average annual growth of around 15 per cent in recent years (Table 12). This would be the slowest pace of growth since 2001/02. Over the next two years, a pick-up in growth in resource earnings, reflecting tight global supplies and large increases in iron ore and coal contract prices, is expected to underpin strong growth in profits. Financials’ profits are expected to grow at a modest pace over the next two years. Growth in other companies’ earnings is forecast to slow a little next year on cost pressures and a moderation in domestic demand.
Net equity raisings picked up in the June quarter, to be close to average levels (Graph 51). While IPOs were limited due to the volatile equity market and lower share market valuations, other equity raisings were robust, particularly for resource companies and other non-financials. Buy-backs were modest, with companies preferring to retain cash to boost reserves rather than rely on access to debt markets in the current environment.
M&A activity has eased a little in recent months, with few large deals announced amidst the volatility in markets. Nonetheless, two large deals are pending: the proposed merger between Westpac and St. George, and BHP’s bid for Rio Tinto.
The turbulence in capital markets continues to affect the cost and composition of financial intermediaries’ funding. Institutions that rely heavily on capital markets, particularly securitisation, to fund their lending have been more affected than institutions with sizeable deposit bases.
Banks’ bond issuance for the first half of 2008 was particularly large at around $67 billion (Graph 52), significantly higher than the average issuance in the first half of the previous three years of $32 billion. Investor demand has been strong, with many issues oversubscribed. Over two-thirds of bond issuance has been offshore and denominated in foreign currencies, particularly US dollars and euros. The major banks have also diversified their funding sources during the credit market turmoil by issuing in the Japanese ‘Samurai’ market for the first time. This market has been more liquid than many others and has also enabled the banks to issue at longer tenors than in some other markets. Samurai bonds have accounted for around 10 per cent of offshore issuance in 2008 so far.
The large banks have indicated that the strong issuance was partly precautionary in case conditions in financial markets were to worsen, and that they are ahead on their funding plans. As well as financing balance sheet growth, which in part reflected re-intermediation, these funds are being used to pay down short-term debt, thereby reducing banks’ refinancing risks.
The average maturity of bonds issued by the major banks has varied considerably in 2008. The average maturity lengthened in the June quarter, having an average tenor of 5½ years, after falling to around 2½ years in the March quarter. Overall, the average maturity of total outstanding bonds has only declined a little.
Spreads on banks’ bonds at issuance remain wider than usual. There were some signs of spreads narrowing in the June quarter, but more recently spreads have increased again. Spreads for 3‑year and 4-year bank bonds issued in July increased by 10–15 basis points, consistent with the increase in secondary market spreads (Graph 53). The increase in banks’ bond spreads occurred in an environment of increases in the price of bank risk globally following Fannie Mae and Freddie Mac’s difficulties, the failure of several US banks and monoline downgrades (Graph 54). Credit default swap (CDS) premia on Australian banks rose by at least 25 basis points, similar to those on banks in most other countries but much less than the 60 basis points for US banks. These increases were partly offset more recently as sentiment improved somewhat in the United States. Late in July, CDS premia in Australia rose a further 7 basis points following the announcement of increases in provisions by a couple of the major banks, though this was later retraced.
There have been some signs of improvement in the securitisation market in recent months, with a number of public issues taking place, though activity remains subdued compared to a year ago. On average, residential mortgage-backed securities (RMBS) deal sizes continue to be smaller than prior to the credit turbulence ($380 million versus $1.6 billion), with fewer investors and deals often tailored for specific investors. The stock of RMBS outstanding has fallen by 25 per cent to $130 billion since mid 2007, reflecting the limited issuance as well as amortisation (Graph 55). There has been no offshore issuance in the past year and so the fall in the stock of offshore RMBS has been greater than that of onshore RMBS (35 per cent versus 10 per cent).
Spreads on RMBS remain elevated. Recently, AAA-tranches of full-doc RMBS have priced at spreads to swap of around 110–120 basis points, compared to spreads of less than 20 basis points prior to the credit market turbulence. This is down from the spreads of 150–200 basis points seen in the secondary market in early 2008 during the liquidation by structured investment vehicles. Spreads would need to fall somewhat further for securitisation to become an attractive source of funding for financials.
Investors are demanding a premium for RMBS with equivalent credit ratings that are backed by higher-risk loans, such as low-doc, non-conforming, or interest-only loans. Spreads on AAA-tranches of low-doc RMBS have priced at around 180 basis points in recent months, and around 300 basis points for the AAA-rated tranche of a non-conforming issue. Both prime and non-conforming senior tranches have been structured with more subordination than required to obtain a AAA rating.
There has also been a trend towards prime RMBS being structured so that the rating of the senior tranche is independent of the credit enhancement provided by lenders’ mortgage insurance (LMI), following concerns about the mortgage insurance and bond insurance sector. For most RMBS issued this year, the AAA-rated tranches have around 1½ times the subordination required to be immune to LMI downgrades. In July, Moody’s downgraded the Australian operations of the main LMI providers in the Australian market, PMI and Genworth, to AA- from AA, following downgrades to the US-based parent companies after they suffered losses in the US housing market. PMI was downgraded by S&P in April. Both rating agencies acknowledged the strength of the local operations of PMI and confirmed it has been successfully ‘quarantined’ so as to maintain a higher rating than its parent. The downgrades of PMI and Genworth have flowed through to around 190 subordinated tranches being downgraded to AA- from AA, though these account for less than 5 per cent of outstanding prime RMBS. The AAA rating of all senior tranches were affirmed, as they have sufficient levels of subordination.
Conditions in the asset-backed commercial paper (ABCP) market remain tight, with some programs only able to issue at short maturities, and spreads near record levels. In May – the latest data available – the stock of ABCP outstanding rose 3 per cent (the first increase since December 2007), though it is still 30 per cent below its peak mid last year (Graph 56). Prime residential mortgages and RMBS continue to account for the bulk of underlying collateral. A couple of institutions are winding down warehouse facilities funded by ABCP that they used to provide to smaller originators, causing them to seek an alternative source of temporary finance until the RMBS market recovers. Some originators have been able to switch to warehouses provided by other banks, though typically these new programs are more expensive.
Deposit growth was particularly strong in the June quarter with both household and non-financial corporate deposits growing significantly. Growth in deposits has been driven by increased demand for low-risk assets and strong competition for deposits from financial institutions. The average interest rate on the major banks’ 3-, 6- and 12-month term deposits was 50 basis points higher in the June quarter than in the March quarter, and rose further in July (Graph 57). Financial intermediaries’ rates on online savings, cash management and bonus saver accounts also increased through the June quarter.
Funding costs remain elevated for financial institutions although the recent decline in bill yields should alleviate this to some extent. These higher funding costs have been passed on to borrowers through higher lending rates (as detailed below). As a result of these higher interest rates, and some tightening of lending standards for some types of borrowing, aggregate credit growth has eased considerably since the end of 2007. After peaking at an average monthly growth rate of 1.3 per cent over the December quarter 2007, total credit grew at an average monthly rate of 0.5 per cent over the June quarter. Year-ended growth has slowed from 16.3 per cent over 2007 to 11.7 per cent over the year to June (Table 13; Graph 58). The slowdown in credit growth is consistent with other indicators of softer demand in the June quarter as discussed in the ‘Domestic Economic Conditions’ chapter. Growth in broad money has continued to ease over the June quarter, following the strong expansion through 2007.
Over the past three months, interest rates on loans to households have continued to rise, despite the unchanged cash rate. The majority of these increases took place in early July in response to the ongoing high funding costs of financial institutions.
Variable indicator rates on prime full-doc housing loans have risen by an average of 18 basis points since the end of April 2008, to be 156 basis points higher than at the end of July 2007 (Table 14). Banks and mortgage originators have increased their interest rates by a little more than credit unions and building societies (CUBS). Interest rates on riskier housing loans have also continued to rise. Since the end of April, the average variable rate on prime low-doc loans (7 per cent of outstanding housing loans) has increased by 24 basis points, while the average interest rate on non-conforming loans (1 per cent of outstanding loans) has increased by around 15 basis points.
The five largest banks’ average 3-year fixed rate on prime full-doc housing loans has increased by 40 basis points since the end of April 2008. The 3-year fixed rate is currently 38 basis points higher than the variable rate on prime full-doc housing loans. Partly reflecting this, the share of owner-occupier loan approvals at fixed rates has roughly halved since March to be broadly in line with its decade average of 12 per cent.
Overall, we estimate that the average interest rate on outstanding household loans has risen by about 20 basis points since the previous Statement, to be around 100 basis points above its post-1993 average.
The increase in borrowing costs, combined with some tightening in lending standards (particularly for riskier borrowers) have contributed to a decline in the value of new housing loans over the first half of 2008. Since December, housing loan approvals have fallen by 20 per cent. The share of owner-occupier loans approved by mortgage originators has continued to decline, to around 4½ per cent in June, compared to 12 per cent in mid 2007, while the banks have continued to increase their market share (Graph 59).
Reflecting the reduction in new loans, housing credit growth has slowed noticeably over the past few months. Monthly growth in housing credit averaged 0.6 per cent over the June quarter, down from 0.9 per cent over the December quarter.
Interest rates on personal loans have also risen over recent months. Average variable interest rates on margin loans, unsecured personal loans and credit cards have increased by between 15 and 35 basis points since the end of April 2008. While higher interest rates on personal loans are likely to be discouraging borrowing, the recent volatility in personal credit growth appears to be largely related to volatility in equity markets. The falls in equity markets have reduced demand for new margin loans, and increased repayments of existing loans – the number of margin calls remained elevated at around 1.7 calls per 1,000 accounts in the June quarter, after peaking at 3.9 calls per 1,000 accounts in the March quarter (Graph 60). With the stock of outstanding margin loans falling by a further 2 per cent in the June quarter to be 16 per cent below its December 2007 peak, personal credit grew by 4.1 per cent over the year to June, its slowest pace of growth in 14 years.
The cost of borrowing has also increased for businesses. Variable interest rates on large business loans, which are mostly priced off bank bill rates, have increased by 15 basis points since the end of April, while variable indicator rates on small business loans have risen by 24 basis points. In contrast, rates on new 3-year fixed loans for small businesses have fallen by 60 basis points over the same period, although much of the decline occurred since mid July, broadly in line with the decline in the 3-year swap rate. Overall, we estimate that the average interest rate on all outstanding business loans is around 8.88 per cent, 100 basis points above the post-1993 average (Graph 61).
In line with higher borrowing interest rates, as well as tighter lending standards, particularly for property, growth in total business debt has eased sharply over the first half of 2008. Total debt grew at an annualised rate of 8 per cent over the first six months of this year, down from an annual rate of 17 per cent over the previous six months. The slower growth in the first half of 2008 largely reflected a pronounced slowing in intermediated borrowing from the rapid growth in the second half of 2007. Intermediated business credit growth weakened in the June quarter, expanding at an average monthly rate of 0.3 per cent, following average monthly growth of 1.8 per cent during 2007. This partly reflects a slowing in the pace of re-intermediation (Graph 62). The stock of outstanding non-intermediated debt has increased over recent months, after falling in the second half of last year, as access to capital markets has improved somewhat for large well-known credit-worthy borrowers. Commercial loan approvals have also fallen significantly in recent months, suggesting demand for borrowing by businesses could remain soft in the near term.
The slowdown in borrowing in the June quarter has been evident across large and small business borrowers. Companies in the finance & insurance and wholesale & retail trade sectors have led the slowdown. Borrowing by mining companies has also slowed. Some of the slowdown in borrowing by large corporates in recent months reflects a sharp fall in borrowing for acquisitions, with these being equity-funded instead (Graph 63).
The value of corporate bond issuance was $10 billion in the June quarter, around the average level of issuance prior to the credit turbulence (Graph 64). While this pick-up in issuance suggests that there has been some improvement in corporates’ access to the bond market, issuance has been by large companies that have a well-established presence in US wholesale markets. The bulk of issuance in June was due to Rio Tinto refinancing debt related to its acquisition of Alcan. Issuance in July was modest, with four relatively small corporate issues.
Spreads on recently issued corporate bonds remain elevated compared to a year ago. In secondary markets, corporate bond yields have fallen by 30 basis points since April, though remain around the highest level in at least a decade (Graph 65). As CGS yields have fallen by more than corporate bond yields over this period, spreads widened further.
As well as higher spreads, investors have increasingly demanded tighter bond covenants following the global reappraisal of risk. There has been an increased use of covenants in corporate bonds issued in 2008 providing greater protection to investors from either a change in ownership or a ratings downgrade. The Australian corporate bond market has also been affected by the recent widespread rating downgrades of monolines, resulting in credit-wrapped spreads on some corporate bonds rising significantly (see ‘Box B: The Domestic Credit-wrapped Bond Market’).