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

Interest rates and equity prices

Money and bond yields

Short-term market rates rose by ¾ of a percentage point in 2006, in line with the three monetary tightenings. They rose further in early 2007, on the back of strong data for Australia and elsewhere, and by mid January the market had almost fully priced in a further 25 basis point rise in the cash rate by the middle of 2007 (Graph 50). These expectations were scaled back significantly, however, following the CPI release in late January. Market pricing at present embodies little prospect of a tightening in monetary policy in 2007.

Yields on Australian long-term government bonds again moved in a narrow range in 2006, reflecting a continuation of the relatively stable conditions that have characterised global bond markets in recent times. Volatility in yields was less than half the average over the second half of the 1990s (Graph 51). Yields on 10-year government bonds recorded a net increase of 70 basis points over the year. Most of this rise took place in the first half of the year; there has been little net change in yields since August, when they reached 5.9 per cent.

While domestic bond yields have generally followed movements in US yields over the past year, their rise over the first few months of 2006 was not as pronounced as that in US yields. This reflected the fact that US monetary policy, at that time, was tightened by a larger degree than had been expected (and by more than in Australia). In contrast, for the rest of the year domestic bond yields held up relative to US yields, reflecting concerns about rising inflation pressures in Australia and the prospect that the US may have reached the end of this phase of monetary tightening. As a result of these developments, the spread between Australian and US 10-year bond yields narrowed from around 80 basis points at the beginning of the year to around 50 basis points mid year but has since widened to around 100 basis points (Graph 52).

Yields on inflation-indexed bonds have moved broadly in line with yields on nominal bonds over the past year with implied inflation expectations, at a little over 3 per cent, showing little net change over the period. As discussed in the past, institutional factors have boosted demand for inflation-indexed bonds relative to nominal bonds. As a consequence, yields on inflation-indexed bonds have been a little lower than they may have otherwise been, making it difficult to use them to draw conclusions about inflation expectations.

The relative movements in short and long-term yields saw the Australian yield curve become a little more inverted over the course of the past year. The yield curve has been inverted for most of the past two years. As mentioned in previous Statements, an inverted yield curve has on occasions signalled expectations of a period of slower economic growth and hence an easing in monetary policy, but this has not characterised market expectations over the past few years. Other factors affecting global markets, in particular strong demand for investments from a variety of sources, have tended to hold long-term yields lower.

Spreads on corporate bonds, which are an indicator of perceived default risk, generally remained low in 2006 (Graph 53). However, spreads on bonds issued by companies that became the actual (or anticipated) targets for takeover, particularly via leveraged buyouts (LBOs), widened noticeably. This was because of the likelihood that many of these deals would result in an increase in the debt-servicing burdens of these companies and, accordingly, in their default risk. For low-rated debt, the premia on credit default swaps – which are financial derivatives that provide insurance against defaults on corporate debt – have also risen recently, mostly due to the increase in LBO activity.

Despite some widening in spreads, Standard and Poor's announced more upgrades than downgrades to Australian corporate credit ratings in 2006. This is a favourable situation, both relative to history and relative to the global bond market in 2006, where more downgrades than upgrades occurred (Graph 54).

The relatively low level of corporate bond spreads is partly due to low default rates in Australia and the rest of the world. Notwithstanding the modest increase in net downgrades to global ratings, the global default rate remains around its lowest level seen in the past 20 years, with less than 2 per cent of global speculative grade issuers defaulting in 2006 (Graph 55). There have been very few corporate bond defaults in Australia in recent years.

Ongoing strong demand for relatively high-yielding bonds from both Australian and non-resident investors has also helped keep spreads quite low. This has been particularly evident in lower spreads on domestically issued residential mortgage-backed securities (RMBS). Although spreads on RMBS increased slightly during 2006, they remain well below the levels seen earlier in the decade (Graph 56). At the end of 2006, the AAA-rated tranches of these securities were issued at around 20 basis points above bank bill rates, compared with around 35 basis points in mid 2002. Spreads on lower rated RMBS have fallen more sharply.

The low level of RMBS spreads is supported by relatively small losses on the underlying loan pools of these securities compared to historical standards. Importantly, investors in these securities have suffered no loss of principal, with any losses on the underlying loans covered by lenders' mortgage insurance and the profits of securitisation vehicles.

Intermediaries' interest rates

Financial intermediaries increased their variable housing loan indicator rates by a cumulative 75 basis points in 2006, with each of the three cash rate increases reflected in indicator rates within a week or so of their announcements.

One of the features of housing interest rates over recent years has been lenders' tendency to discount, relative to the indicator rate, the actual rate that borrowers pay. The available evidence suggests that the average size of discounts offered to borrowers may be starting to stabilise at around 60 basis points, and that almost all new borrowers receive a discount (Graph 57). While discounting has limited the rise in interest rates on new loans over recent years, actual housing rates are around 80 basis points above their decade average (Table 10). In addition, because the current tightening cycle has been relatively long and a large proportion of the loans outstanding have been taken out in recent years, a relatively high proportion of current borrowers are paying a higher rate than when they took out their loan.

Interest rates on fixed-rate loans did not rise as much as those on variable-rate loans in 2006. The major banks' average 3-year fixed rate on housing loans is currently 7.3 per cent, up 60 basis points over the year, and 15 basis points below the average actual variable rate (Graph 58). The share of new housing loans at fixed rates grew steadily through 2006. In November (the latest month for which data are available) fixed-rate loans accounted for 21 per cent of owner-occupier loan approvals, their highest share since 1998. This appears to reflect both increased demand, with borrowers concerned by the prospect of further rises in interest rates, and increased competition between banks to supply such loans. The latter is evidenced by the fact that banks increased the interest rate on new fixed-rate loans in 2006 by only a little more than half the increase in their cost of funding such loans.

Banks have been willing to cut their margins on housing loans over recent years because of the extremely low losses from default on residential mortgages. In 2006, losses on fully documented, prime housing loans, expressed as a percentage of loans outstanding, averaged 0.01 per cent, or 1 basis point, less than a third of their level in 2000. Losses on sub-prime loans have risen to around 20 basis points in 2006, but these losses appear to have been adequately covered – at least to date – by the 290 basis point average interest spread on these loans (Table 11). Arrears on housing loans have risen over the past year but remain at reasonably low levels by historical standards.

On personal loans and standard credit cards, most lenders increased interest rates shortly after each of the monetary policy tightenings in 2006. But competitive pressures were clearly evident in the low-rate credit card market, with most providers passing on only part of the tightenings, often with a significant lag. Since the end of 2005, the average interest rate on low-rate credit cards has risen by only 25 basis points, to 11.45 per cent.

Intermediaries increased their indicator rates on variable-rate business loans by the full 25 basis points following each of the tightenings in 2006. But, consistent with previous years, competitive pressures in the business loan market have meant that the weighted-average interest rate actually paid on variable-rate business loans – incorporating risk margins – has risen by a smaller amount. Business variable rates remain around their decade average (Table 10).

In contrast to lending rates, the pass-through of the 2006 cash rate increases to rates on deposit accounts was quite mixed. Interest rates on online savings accounts, the most competitive part of the deposit market, rose by an average of 50 basis points, to 5.9 per cent. Average interest rates on cash management accounts and bonus saver accounts rose by more than the cash rate during 2006 but this was largely due to a couple of financial institutions increasing their interest rates significantly to make their products more competitive with online savings accounts. Rates on other such deposit accounts were little changed while rates on transaction accounts remained close to zero.

Equity markets

The ASX 200 rose by 19 per cent over the course of 2006. This represents the fourth consecutive year of positive returns and the third consecutive year in which the Australian index outperformed overseas share markets (Graph 59). So far in 2007, the share market has risen by 4 per cent, reaching new record highs. The ASX 200 is currently around 115 per cent higher than the trough in March 2003.

Unlike in 2005, when resource companies' share prices increased by nearly 50 per cent, the rise in the ASX 200 in 2006 was quite broadly based. Resource companies' share prices increased by 15 per cent last year, which was below the 20 per cent increase in the share prices of non-resource companies.

The general strength in equities in 2006 was underpinned by strong profit results for ASX 200 companies. In terms of profits in the future, there were sharp upward revisions during the first half of 2006 to expectations for resource companies' earnings per share (EPS), followed by some modest downward revisions in the second half of the year. Despite these (modest) downgrades, analysts currently expect resource companies' EPS to increase by 32 per cent in 2006/07 and by a further 4 per cent in 2007/08 (Graph 60). For non-resource companies, analysts currently expect EPS growth of 8 per cent in 2006/07 and 9 per cent in 2007/08. For all ASX 200 companies, EPS are forecast to increase by 14 per cent in 2006/07 and around 7 per cent in 2007/08.

In recent months, part of the strength in the share market has been due to merger and acquisition (M&A) activity. Although the value of deals finalised in 2006 was similar to 2005, deals pending lifted the level of activity to roughly double that seen in 2005 (Graph 61). The value of M&A activity in 2006 was equivalent to about 10 per cent of the capitalisation of the Australian share market.

The value (including both the debt and equity funding) of domestic LBOs that have been completed or have been recommended by the company's board rose sharply in 2006 to $27 billion, compared with an annual average of $1½ billion over the previous five years. The December quarter alone saw completed or pending LBOs amount to $19 billion (Graph 62). LBO activity is likely to remain strong in 2007, with private equity firms reported to be preparing bids for several large listed companies. The surge in LBO activity in Australia, as well as abroad, has been largely driven by the low cost of debt relative to returns on equity (Graph 63). Strong inflows into private equity funds, largely from superannuation funds, and a favourable economic outlook have also contributed to the increase in LBO activity.

An LBO typically results in a significant increase in the bought-out company's debt-to-equity ratio, making it more vulnerable to rising interest rates or a deterioration in economic conditions. To date, the impact on the broader economy has likely been limited, as only a very small proportion of the Australian corporate sector has been acquired through LBOs. But if the current surge in LBO activity continues for some time, the increase in corporate leverage could become a longer-term risk to macroeconomic stability.

A third, but relatively minor, factor supporting share prices has been strong debt-financed demand for Australian equities from retail investors. (See section below on intermediated financing.)

Despite the strong rise in share prices, aggregate measures of share market valuation improved slightly over the course of 2006. The ratio of share prices to actual earnings per share – the P/E ratio – fell from 18 to 17, with the gain in share prices being more than matched by the rise in profits. At its current level, the Australian P/E ratio is only slightly above its long-run average and in line with P/E ratios for world equity markets. The dividend yield on Australian shares remained broadly unchanged over the course of 2006 and currently stands at 3.6 per cent, which is around its historical average (Graph 64).

Financing activity

Intermediated financing

Total credit expanded by nearly 15 per cent over 2006, well above the growth rate of nominal GDP and somewhat above the average rate of growth in recent years (Graph 65). Growth in business credit was stronger than for household credit, which slowed a little later in the year (Table 12).

Growth in business credit was particularly strong early in 2006. It slowed through the year, but nonetheless remained rapid. Data on banks' business lending by size of facility suggest that much of the strength in business credit has been driven by large loans (those greater than $2 million). Part of the growth in large loans has come from syndicated lending, which increased by about 15 per cent in 2006.

Following a pick-up around the middle of 2006, demand for housing credit appears to have eased in recent months, consistent with the three cash rate increases during last year having had some dampening effect. The slowing in housing credit growth has been broadly matched by a decline in approvals of new loans, which fell by 6 per cent over the three months to November (Graph 66). This suggests the slowing in housing credit growth is largely attributable to the extension of fewer new loans rather than faster repayment of existing loans. The moderation in demand for housing credit occurred in both the owner-occupied and investor components.

Growth in personal credit, which is quite volatile from month to month, has been slightly weaker than growth in housing credit, increasing by 13 per cent in 2006. Within personal credit, growth in margin lending for the purchase of shares and managed funds increased by 41 per cent to $28 billion (Graph 67). The strong growth in margin loans outstanding over the year was driven by large increases in both the number of loans and their average size. Indicators of the riskiness of borrowers' margin loan positions, such as the average gearing level and the proportion of available credit limits used, picked up slightly in 2006 but remain low by historical standards.

Non-intermediated financing

Net issuance of bonds by Australian non-government entities amounted to $92 billion in 2006, 17 per cent more than in 2005 (Table 13). This was driven by a pick-up in both onshore and offshore issuance; the increase in onshore bond raisings was largely due to asset-backed vehicles, while the rise in offshore issuance reflected raisings by financial institutions. Strong investor demand and favourable conditions in currency swap markets made it attractive for the major banks to issue large volumes offshore in foreign currency and swap into Australian dollars. In total, offshore net issuance accounted for around half of raisings by Australian non-government entities in 2006.

Non-residents were also active in issuing A$ bonds in the domestic bond market in 2006, raising a net $27 billion. The strong growth in the value of non-residents' bond issues suggests that the Australian market continues to be an internationally competitive source of debt finance.

Total outstandings of non-government bonds in the domestic market rose strongly in 2006, to exceed $300 billion (Graph 68). This greatly exceeds the amount of Commonwealth and State government bonds outstanding, of around $50 billion each. Non-residents and asset-backed vehicles each accounted for a large part of the increase in outstanding non-government bonds.

Capital raisings other than bonds were also generally strong in 2006. Net equity raisings exceeded $30 billion, with most of this accounted for by companies already listed; IPO activity fell from the very high levels recorded in 2005.

Reflecting these developments, total net capital raisings – debt, hybrids and equity – for the Australian non-government sector in 2006 were 36 per cent higher than in 2005. However, this was entirely due to strong raisings by financials and asset-backed vehicles; net capital raisings by non-financial corporates were broadly unchanged in 2006 (Graph 69). This latter group relied more on intermediated funding and high levels of profitability to fund investments.