Transcript of Question & Answer Session The Australian Bond Market

I appreciate you don’t want to talk about other stuff, but in relation to what was you were saying about corporate bond markets, is that one reason why the Australian dollar has been up more than the Bank thinks it should be?

So, what the corporate bond …

The foreign demand for corporate bonds. How much of that is playing out in that high dollar story and what might happen to the way foreign investors in the corporate bond market …? Is the dollar worth the levels … [inaudible]?

While a large share of the corporate bond market is held offshore because the corporate bond market is a lot smaller than the Commonwealth bond market, so a decent chunk of the inflow over the past few years has been Commonwealth bonds. Asset managers buying Commonwealth Government bonds, so that’s been a capital flow which wasn’t very evident a few years prior to that. It’s been decent capital inflow to the Commonwealth Government bond market, so other things equal, this pushes the currency up. On the other hand, the top right hand corner, the banks have been issuing a lot less so there’s been much less capital inflow into bank bonds than there had been previously so that’s pushing the currency down.

The dominant form of capital inflow over the last few years has been to fund mining investment, not so much through the bond market actually just direct funding brought in off the balance sheets of the big miners for all the investment spending they’ve got. That’s been by far and away one of the biggest sources of capital inflow for Australia over the past three or four years or so. To the extent that investment spending is starting to come off, so is the capital flow into that part of the foreign investment pie starting to come down too. So there’s at least one major form of financing that’s in the process of changing direction. How much that affects what happens to these other flows, you know that one’s reasonably easy to predict. The other flows are much harder.

Question about the secondary market for Australian bonds. It is virtually non-existent.

A couple of things have happened in that space just recently. One is that the ASX has now got its retail facility but liquidity comes from institutional investors not retail. But anyway you can now buy and sell Commonwealth Government bonds through the ASX, just like you can with shares. So the ASX started with CGS last August, their intention is to broaden that out to corporate bonds as well.

Part of a potential constraint around the corporate bond market is the size and complexity of the prospectus. The government has been working on simplifying that. Now that again is something probably more to do with the primary market. The particularly in the Commonwealth and the states there are designated market [inaudible]. But we don’t see it as a necessary role for us in that market. As you said, the corporate bond market. Again, I think depending on how the ASX facility goes that’s one potential way to address … [inaudible] and there will be a market providing some sort of [inaudible]. That’s something we’re involved in … [inaudible]… some problems. We do provide a liquidity backstop in at least …[inaudible] for all of those types of bonds in terms of the bonds being repo eligible, that’s not to prevent them from being [inaudible] which provides some sort of [inaudible]. But it’s not – are we a direct market maker in bonds.

It’s not institutional … [inaudible]. And yet Australia has never set up … [inaudible].

No, that’s what I’m saying, the ASX has. Yeah I know, I know, but the question is … [inaudible]

I’m not sure about that, but it’s … So we’re buying corporate paper then we’re having direct exposure to the … [inaudible].

[inaudible].

But as I said that’s what the ASX is – it’s a long way down the path and very much intends in the near future to broaden that into corporate bonds. [Inaudible.] I’d say it’s more progress there in the last two years than there has been in the previous … [inaudible].

There was a paper last week from JP Morgan suggesting that the decline in bond yields is creating conditions for the great moderation to reassert itself to the world, so the volatility in all bond markets reduces as indeed macroeconomic conditions improve. Do you see, I’d be interested in your comment on that thesis and also do you see that creating conditions for the carry trade to be developed as a significant factor in the Australian bond market?

Let me answer the question first. I’m not sure that we’ve seen the end of volatility. I’m guessing at around about this time next year if market forecasts and future policy actions are right we might see a pick-up in volatility, so I’d be loath to predict an end to volatility at this point. While we may see an improvement in macro outcomes, and we have, my guess is when short-term interest rates are no longer at zero in the US, a few things might get flushed out. Let’s see where we are in 18 months’ time but I’m guessing so volatility is low at the moment, that’s true. We saw a burst of volatility this time last year when the concerns about the Fed tapering first emerged. My guess is though when we actually see short-term interest rates actually rise volatility is probably going to pick up, I’m guessing there’s a few financial structures out there which are predicated on the fact that they can borrow at zero or near zero interest rates. Beyond that there’s a lot [inaudible] so I’m not sure about that. I mean, to the extent, in terms of capital flows I mean an environment of lower volatility is a bit … [inaudible] because you don’t have to worry so much about volatility around that. I’m not sure that we are necessarily closer to that today … And we’ve seen over the last few months the resumption of capital flows … [inaudible].

Could that be a factor pushing the dollar higher over the past few months?

I don’t know. I have no explanation for why the currency’s gone up, so I’m not [inaudible].

Question about bond yields.

Well no I mean I think yields have been driven low right across the spectrum because people are [inaudible]. If you’re only getting say in the US for investments out on the six to 12 months horizon zero and you’re after some sort of yield then you’ll move – the only way you can get yield is to move further out along the risk spectrum and as more and more people are doing that it’s pushing those instruments down as well. As I said how much of that is likely to survive when we’re no longer in a zero interest rate environment … goes back to David’s question.

Question about Australian bonds held offshore.

No because Australians don’t hold much fixed income, but on the other side Australian pension funds invest a lot offshore, so we hold more offshore equity than foreigners hold equity in Australia, we put that out for the first time at the end of last year. So Australians hold more equity offshore, so there’s a difference between what instruments people hold, and we hold more equity than foreigners hold equity in Australia. But on the flipside they hold more of our bonds than we hold more of their bonds. But the net of that, the net of savings and investment is the current account, and the current account is indeed still in deficit but it’s the smallest today than in thirty-five years. So yes, we save less than we invest but that’s partly because we’re just coming off one of the highest levels of investment as a share of the economy that we’ve ever had.

Questions about the stock of foreign liabilities.

So if you look at Australia’s stock of foreign liability so the accumulated stock, what we were just talking about, so they’re actually declining as a share of GDP and the prospect is that’s likely to continue going forward because the current account deficit is shrinking, it’s now below the level which would stabilise the stock of foreign liabilities [inaudible]. So that dynamic had been true since the mid-late 80s and has started to turn around in the last six to 12 months, and it’s likely to continue. I mean we’ve given the structure of our economy where there has been the need for a lot of investment, particularly in …. [inaudible].

When do you think the US Treasury bond market will collapse?

I don’t think it’s going to collapse. Do I think yields will go up at some point? Yes. Will that transition from the yield curve we’ve got today to a higher yield, it could be a little bit messy at some point but I’d be surprised if it wasn’t, historically that’s been the case. I mean the only thing which we’ve … I think the only thing which could generate a rapid pick-up in bond yields is inflation, and at the moment it’s not there, if anything there are concerns about the opposite. So the day when those figures start to re-emerge will be when … [inaudible].

Thanks very much for the questions.