Statement on Monetary Policy – February 2008
Domestic Financial Markets and Conditions
Money market and bond yields
The volatile conditions described in the chapter on ‘International and Foreign Exchange Markets’ were also evident in Australian markets. Domestic money markets came under renewed strain in November, with the spread between 90-day bank bill yields and the expected cash rate path rising to a peak of 55 basis points in mid December, around the highs reached back in September (Graph 46). The primary cause of the rise was year-end funding pressures evident in global money markets. Because of the disruptions to foreign exchange swap markets reflecting reduced ability to access USD funding markets and tight limits from counterparties, the cost of raising short-term Australian dollar funding through offshore markets such as LIBOR rose more than the cost in domestic markets.
The RBA responded to the increased demand for liquidity by frequently dealing more than the projected system deficit and making term funding available in its open market operations, ensuring that the bulk of repurchase agreements extended over year-end. As a result the aggregate volume of exchange settlement (ES) balances rose to a peak of $6.8 billion, well above the levels of less than $1 billion that had prevailed prior to August (Graph 47). The aim of the Bank’s monetary operations, as always, was to ensure that the cash rate remained at the target set by the Reserve Bank Board. In the event, this goal was achieved with the cash rate only falling 1 basis point below target on two days.
While financial markets in general have remained volatile into 2008, conditions in money markets appear to have improved. The spread between 90-day bank bills and the expected cash rate has narrowed back to around 30 basis points. The RBA has wound back its supply of short-term liquidity which has seen ES balances decline to around $1¾ billion. Short-term bill rates, however, remain above their levels at the time of the last Statement, as the narrowing in spreads was offset by an increase in the expected cash rate.
Domestic long-term interest rates are around the same level as at the time of the last Statement, although the yield on 10-year government bonds has fluctuated within a 60 basis point band over the period. This is in contrast to yields in the US and other major economies which have declined significantly. As a result, the spread between Australian and US 10-year government yields widened further to be at its highest level since the mid 1990s (Graph 48). The widening spread reflects the difference in economic outlook for the two economies.
After increasing strongly through most of 2007, the fifth consecutive year of strong gains, the Australian equity market has fallen sharply in recent months in line with the weakness in global equity markets (Graph 49). Volatility has also increased: on 22 January the ASX 200 fell 7 per cent – the largest daily fall since 1989 – only to recover this fall in the following two days. The ASX 200 is down 12 per cent in 2008 to date, and is 18 per cent below its peak on 1 November 2007.
The fall in the Australian market has been broad-based, but has been more pronounced for financials (Graph 50). Australian banks have been marked down along with banks globally, despite having relatively little exposure to the US sub-prime housing market. Concerns about US growth and weakening commodity prices have weighed on resource stocks. In addition, the share prices of a few companies that are having perceived or actual difficulties refinancing short-term debt have fallen very sharply. While there may be further instances of corporates running into difficulties rolling over debt, this does not appear to be a large risk to the Australian corporate sector. Overall, the current level of gearing in the Australian corporate sector is not high on an historical basis and the reliance on short-term debt among medium to large companies is moderate.
Following the fall in share prices in January, P/E ratios fell so as to be a few points below their average levels across all sectors (Graph 51). Similarly, the dividend yield picked up in January to 4.1 per cent, slightly higher than its longer-term average.
Over the last few months, analysts have lowered their earnings growth estimates for 2007/08 by a couple of percentage points. Resources sector earnings growth is expected to slow from 29 per cent in 2006/07 to 3 per cent in 2007/08 and then pick up to 23 per cent in 2008/09. Financials’ earnings are expected to grow at around 9 per cent for each of the next two years, while other companies’ forecast earnings growth is only expected to be 2 per cent in 2007/08, but to rebound to 11 per cent the following year.
The turbulence in capital markets has increased the cost and affected the composition of funding of financial intermediaries. Institutions that rely more heavily on capital markets to fund their lending (such as mortgage originators) have been most affected compared with other institutions which have a larger deposit base. Securitisation markets remain particularly difficult, limiting this source of funding.
Banks have continued to raise significant amounts of short-term funding, particularly in domestic capital markets, despite the cost of that funding rising markedly (Graph 52). Domestically, banks have increased their issuance of bank bills to around $20 billion a month since July from an average of $5 billion a month in the 18 months prior. The major banks have also maintained a significant presence in public longer-term capital markets, with issuance being particularly strong in January. Moreover, in recent months, private placements – for which details are often not publicly available – have been higher than usual. However, the spreads on banks’ bonds at issuance have widened noticeably. Some of the major banks issued 3-year bonds at an average spread to swap of 47 basis points in January, well above their average spreads of around 10 basis points prior to the credit market disruption, and an increase from the 30–32 basis points in September 2007 and 40 basis points in November 2007 (Graph 53). Mirroring the rise in bank bond spreads, CDS premia on the major Australian banks have increased by around 20 basis points since their recent trough in December. While elevated, they remain significantly lower than those on US banks, in part reflecting the limited exposure Australian banks have to the US sub-prime market.
While on-balance sheet funding in the form of bank bills and bonds has been strong, securitised funding has been particularly affected by the financial turbulence. The latest issuance data available indicate that in November the value of asset-backed commercial paper (ABCP) outstanding stabilised after several months of falls (Graph 54). Between end July and end November, Australian conduits’ ABCP fell 13 per cent, significantly less than the 31 per cent decline in US ABCP outstanding. In part, the somewhat better performance of the Australian market probably reflected the different purpose of ABCP conduits in Australia, which are predominantly used to fund loans; in the United States they are more frequently used to fund securities. Liaison with local counterparties suggests that access to funding has improved a little but remains tight, with investors requiring more transparency regarding the collateral backing ABCP. Spreads remain at elevated levels and most paper continues to be issued at short maturities (Graph 55).
Issuance in the longer-term securitisation market has been very low and spreads on RMBS at issuance remain wide (Graph 56). Both the number of RMBS and the average size of each issue have been small – deal size has averaged $370 million since September, well below the average of $1.6 billion prior to August 2007. Those financial institutions which were highly reliant on securitised funding have significantly curtailed their lending.
Overall, banks, which supply about 85 per cent of intermediated finance, have been able to continue to expand their funding at a solid pace, with around average growth in foreign liabilities and in deposits from both households and non-financial corporates, and above-average growth in domestic capital market liabilities (Graph 57). Consequently, despite the turbulence, bank lending continued to grow at a brisk pace during the December quarter. Total credit grew by 16 per cent over 2007, its fastest pace since the late 1980s (Graph 58, Table 10).
At the time this Statement was finalised, the February increase in the cash rate had only just started to flow through to borrowing rates.
Over the past couple of months, intermediaries have raised interest rates on loans to households in response to the higher cost of funds. In January, the five largest banks increased their variable housing rates on prime full-doc loans by an average of 15 basis points (Graph 59). Most of the smaller banks and several credit unions and building societies also increased their variable housing rates by a similar amount. Mortgage originators have increased their variable housing rates only slightly in January, as their rates had risen by more than the cash rate in late 2007. By the end of January, the average variable housing rate across all lenders had risen by around 40 basis points since the previous Statement to 8.06 per cent.
Interest rates on riskier housing loans have also continued to rise. The average variable rate on prime low-doc loans (7 per cent of outstanding housing loans) rose by 36 basis points between the last Statement and the end of January (Table 11). Interest rates on non-conforming loans (1 per cent of outstanding housing loans) rose by 56 basis points, and, as noted above, institutions in this market have slowed their lending volumes in response to the market turbulence.
The five largest banks’ average 3-year fixed rate on prime full-doc housing loans is currently 8.47 per cent, 60 basis points higher than at the time of the last Statement (Graph 60). Smaller banks’ and mortgage originators’ 3-year fixed rates have increased by about 50 basis points. Despite these increases, the share of owner-occupier loans approved at fixed rates continues to rise, reaching 24 per cent in November, well above its decade average of 12 per cent.
With fixed and variable rates having risen sharply over the past year, we estimate that by the end of January the average interest rate on all outstanding household loans had risen to 8.5 per cent, 30 basis points above the post-1993 average and around 200 basis points above the low in 2002. Reflecting this increase in borrowing costs, housing credit growth has slowed to 11.6 per cent over the year to December, around the slowest pace in almost a decade. The value of home loan approvals has also slowed. The value of owner-occupier housing loans approved by mortgage originators – which are heavily reliant on capital market funding – fell by almost 40 per cent over the four months to November. However, the banks appear to have picked up most of this business (Graph 61).
Interest rates on personal loans have also risen over recent months. Between the last Statement and the end of January, average variable interest rates on margin loans, unsecured personal loans and credit cards have increased by between 30 and 45 basis points. Nevertheless, personal credit grew by 13.1 per cent over 2007, around the average pace of growth over the past decade. A significant contribution to this growth came from margin lending, which grew by 40 per cent, as investors continued to borrow to buy equities, despite sharp equity market corrections in August and in December. The number of margin calls per day per 1,000 clients averaged 0.9 in the second half of 2007. This was roughly double its average over the past three years, but was still low by historical standards, largely due to borrowers’ low average gearing levels. The sharp fall in the Australian share market in January saw a significant increase in margin calls.
There has been a marked change in the composition of business financing as a result of the financial market turmoil. Corporate debt issuance was almost non-existent in the second half of 2007, with businesses increasingly turning to the banking sector for funds. Total business debt increased by 19 per cent over 2007, the fastest growth since the late 1980s (Graph 62). Equity raisings have not been significantly affected by the credit market volatility. Net equity raisings totalled $30 billion in the second half of 2007, up from $22 billion in the first half (Graph 63). While this partly reflected very strong raisings in July, activity for the rest of the period was around average levels.
Business credit growth was broad-based across borrowers over 2007. Strong growth was recorded for lending to both corporations and unincorporated entities, although lending to corporations (which makes up around 60 per cent of total business credit) has grown particularly rapidly. Consistent with this, syndicated lending is estimated to have increased by about 45 per cent over 2007. Syndicated loans have been a particularly attractive source of finance for large corporates compared with capital market raisings over the past six months as they are quicker to arrange, offer greater certainty of pricing, and are negotiated privately rather than in public markets. These loans have been mainly used to fund merger and acquisition (M&A) activity, which remained strong in the second half of 2007 despite the dislocation in securities markets. There has also been a pick-up in lending for general corporate purposes and capital expenditure.
The rapid growth in business credit has occurred notwithstanding an increase in borrowing rates, as businesses have continued to experience significant pass-through of the increase in banks’ wholesale funding costs. Around 45 per cent of large business loans (those greater than $2 million) are directly priced off bank bills, which remain at elevated levels. The four largest banks have increased their large and small business variable indicator rates by an average of 50 basis points between the last Statement and the end of January (Table 12). Small business 3‑year fixed rates have risen by 25 basis points. We estimate that the average interest rate on all outstanding business loans was around 8.0 per cent at the end of January, 25 basis points above the post-1993 average and about 185 basis points higher than the low in 2002.
Yields on corporate bonds have also moved higher (Graph 64). Perceptions of higher corporate credit risk have also intensified in CDS premia. CDS premia on A-rated and BBB-rated corporates increased 65 and 80 basis points respectively since end October. This has brought premia back to around levels prevailing in late 2002.
There has been little impact on outstandings of insured corporate bonds – or credit-wrapped bonds – from the downgrade of several insurers. Spreads on these bonds have increased by around 15 basis points, similar to other AAA bonds, and, at this stage, only a few Australian credit-wrapped bonds have been downgraded from AAA in line with the insurers’ lower rating. Insured bonds currently make up about 7 per cent of the domestic non-government bond market.