Statement on Monetary Policy – August 2007 Domestic Financial Markets and Conditions

Interest rates and equity prices

Money and bond yields

Since the cash rate was last increased in November 2006, markets had assigned some probability to the need for a further increase. These expectations increased in the first half of June, prompted by the release of several indicators pointing to continued strength in the domestic economy and growing confidence that global activity would remain buoyant (Graph 50). Market expectations were scaled back somewhat over the next month or so, but shifted upward again in late July following the June quarter CPI release. By late July, the market had almost fully priced in a 25 basis point rise in the cash rate at the August board meeting. The turbulence in global credit and equity markets around that time had little effect on these expectations. In the event, the announcement of an increase in the cash rate to 6.5 per cent had little impact on financial markets.

There have been quite sizeable movements in long-term interest rates since the last Statement, primarily reflecting global long-term yields (Graph 51). Yields on 10-year Commonwealth Government securities (CGS) rose by almost 50 basis points in May and early June to reach a five-year high of 6.3 per cent in line with a similar rise in US yields. This rise in yields was substantially reversed over the second half of July reflecting the large fall in global yields as financial markets became increasingly concerned about credit quality. By early August, yields on domestic 10-year government bonds were around 6.1 per cent, some 25 basis points higher than in early May and around 25 basis points below their mid-June peak.

Despite broadly tracking US markets, movements in CGS yields have been a little less volatile than in the US. Domestic yields did not rise by as much when US yields rose in May and early June and have not fallen by as much since then. As a result, the spread between Australian and US 10-year bonds hasfluctuated between 100 basis points and 125 basis points since the last Statement. It is currently around 120 basis points, similar to its level at the time of the last Statement.

The fall in CGS yields was not matched by movements in other long-term yields, such as swap yields. The spread between yields on 10-year swaps and CGS widened significantly in July – it is now around 70 basis points, having been steady at around 50 basis points over the past few years (Graph 52). This is the widest spread over the past decade. A widening of this spread is normally associated with periods of heightened financial uncertainty, when investor demand for the security of risk-free assets increases. As with CGS yields, the widening in swap spreads tracked that in the US.

Yields on state government securities (semis) have moved with the swap rate rather than with CGS yields. The semis' spread to CGS yields has also widened by around 20 basis points. With most states' credit ratings at AAA, however, credit risk considerations do not appear to be a factor.

The heightened uncertainty has also been reflected in increased premia on credit default swaps (CDS) – financial derivatives that provide insurance against defaults on bonds – for local banks' debt, though the rises have been much less than for similar instruments issued on US and European banks (Graph 53).

Premia on corporate CDS have also shown a noticeable uptick in view of the increased volatility in global equity and credit markets in July, rising to levels last seen in mid 2004 (Graph 54). The latest rise has occurred across the corporate sector, in contrast to the increase earlier in the year when it was largely confined to a subset of companies that were takeover targets in leveraged buyout deals.

Despite the pick-up in corporate bonds spreads, default rates remain low, both in Australia and overseas. There has not been a (rated) corporate bond default in Australia for three years. S&P downgraded the ratings of a few Australian companies in the June quarter, including the takeover target, Rinker, which was downgraded to that of its acquirer, Cemex, but overall, the ratings experience for Australian companies over the past year has been positive. The global speculative-grade default rate is close to its historical low at 1.5 per cent in July (Graph 55). While Moody's expects the default rate to pick up a little over the next couple of years, it is forecast to remain at relatively low levels.

Rising concerns about the fragility of the US housing market have had a relatively modest impact upon the domestic residential mortgage-backed securities (RMBS) market. Spreads on RMBS at the time of issuance have remained close to historically low levels (Graph 56). Several recent issues have been oversubscribed, though in early August one institution decided to temporarily delay bringing an issue to market. The low level of RMBS spreads continues to be supported by the fact that investors in these securities have suffered no loss of principal, with any losses on the underlying loans after the sale of the property being covered by lenders' mortgage insurance and the profits of securitisation vehicles.

Intermediaries' interest rates

Most financial intermediaries' variable housing loan indicator rates have not changed since the time of the last Statement. At the time of writing, intermediaries were yet to raise lending rates in response to the August monetary policy tightening. After taking into account discounts, which are now received by almost all borrowers, the average variable housing rate paid by new borrowers is currently 7.45 per cent (Graph 57).

Strong competition has caused interest margins on prime low-doc loans to decline sharply over the past two years. Relative to prime full-doc loans, the interest premium on prime low-doc loans was 15 basis points in December 2006, down from 100 basis points in 2003. Increased competition from the five largest banks in the low-doc loan market, combined with small realised losses on low-doc loans over recent years, have driven the fall in the interest premium (Graph 58).

The five largest banks' average 3-year fixed rate on housing loans is currently 7.70 per cent, 25 basis points higher than at the time of the last Statement. A 45 basis point increase in the 3-year swap rate, which approximates the cost of funding these loans, has underpinned the rise.

Interest rates on variable-rate business loans were little changed in the March quarter (the latest period for which data are available) (Graph 59). The average 3-year fixed rate on small business loans has risen by 35 basis points to 8.55 per cent since the last Statement, broadly in line with the rise in the 3-year swap rate.

Equity markets

Having risen to a record high during July, the ASX 200 has fallen by 5 per cent over the past two weeks (Graph 60). The local market's fall followed declines in the US and other major markets reflecting the developments in global credit markets. Notwithstanding the recent decline, the Australian share market has tended to outperform the major share markets; over the year so far, the ASX 200 is up 8 per cent, compared with around 5 per cent for other major markets (Table 12). This follows four consecutive years of very strong returns in the local market, averaging about 17 per cent per year. The resources sector continues to underpin the local market, having risen by 26 per cent since the start of the year, similar to the average annual increase over the previous four years. The decline in the share prices of retail banks has been similar to the overall market, though the prices of diversified financial companies – whose activities cover investment banking – have fallen by around 15 per cent over recent weeks.

While analysts have revised upward their forecasts for resource companies' earnings for the next couple of years, they continue to expect growth to slow – from 24 per cent growth in 2006/07 to 11 per cent in 2007/08 and 8 per cent the following year (Graph 61). This still leaves the level of earnings per share at an historically high level. Earnings for financial and other companies are expected to increase by between 7 and 10 per cent per annum over the next few years.

The P/E ratio – the ratio of share prices to earnings per share – on both a trailing basis (which uses actual earnings over the past year) and a forward basis (which uses expected earnings over the next year) continues to be a few points above its long run average (Graph 62).

Merger and acquisition (M&A) activity has been buoyant (Graph 63). In 2006, completed M&A deals totalled around $100 billion, representing about 8 per cent of local share market capitalisation. Currently, there are around $90 billion of deals pending. Many of these deals have relatively low gearing as the offers are predominantly made up of shares of the acquiring company and hence may not be significantly affected by the stresses evident in the global credit markets. In contrast, highly-leveraged deals associated with private equity and which rely on the smooth functioning of the leveraged loan market are more likely to be put on hold.

Financing activity

Credit growth has picked up over the first half of 2007 from the rates seen in the latter part of 2006 (Graph 64 and Table 13). Total credit grew at an average monthly rate of around 1.2 per cent over the five months to May, before increasing sharply to 1.8 per cent in June. Growth in June, however, appears to have been boosted by households borrowing to fund superannuation contributions ahead of the rule changes at the end of the month. The increase in the rate of credit growth during 2007 has been broad-based across the business and household sectors.

Household financing

After slowing over the latter part of 2006, housing credit growth has picked up this year to an average monthly rate of 1 per cent over the five months to May and 1.5 per cent in June. The pick-up over the first five months of 2007 largely reflected increased new lending for housing rather than slower repayment of existing debt (Graph 65). However, credit growth in June appears to have been boosted by borrowing to fund superannuation contributions.

While the large increase in personal credit growth in June partly reflected households borrowing to invest in superannuation, growth has tended to be stronger over recent months (Graph 66). Within personal credit, margin lending for the purchase of shares and managed funds has grown very strongly, with large increases in both the number of loans and the average loan size.[1] There were few margin calls in the June quarter, as the equity market was fairly stable, and borrowers' average gearing levels were low by historical standards. No data are available for July to assess the effect of the recent falls in equity markets. While several margin lenders allowed holdings in Basis Capital funds to be used as collateral, the number of affected clients appears to be very small (see chapter on ‘International and Foreign Exchange Markets’).

Reflecting the pick-up in credit growth, net non-intermediated capital raisings by financials and asset-backed vehicles have been strong, totalling $46 billion in the June quarter (Graph 67). Net bond raisings by asset-backed vehicles reached a record high, with robust issuance both onshore and offshore. While net bond issuance by financial institutions was subdued, this was offset by strong short-term raisings.

Business financing

Total business debt increased at an annualised rate of 20 per cent over the six months to June; this was the fastest growth since the late 1980s (Graph 68). Within the total, business credit grew by 22 per cent; lending to corporations (which comprises 60 per cent of total business credit) has grown particularly rapidly, although lending to unincorporated entities has also risen. Companies in the infrastructure, industrial and finance & insurance sectors have recorded the strongest growth in borrowings.

In contrast, growth in corporates' non-intermediated debt, which includes bonds and short-term paper, grew more slowly at around 12 per cent over the same period. Despite the robust growth in total debt, business' balance sheets appear to be in good shape. Debt remains at moderate levels as a share of both equity and profits, and the interest-servicing burden is low (see ‘Box D: Recent Developments in Corporate Gearing in Australia’).

Businesses have also raised significant quantities of equity. Net external equity raisings were around $7 billion – IPO activity and seasoned equity raisings picked up in the quarter though buybacks also increased (Graph 69).


Some margin loans are made to businesses and trusts, and hence are captured in business credit rather than personal credit. [1]