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

Interest rates and equity prices

Money and bond yields

Short-term interest rates have fluctuated over the past few months, though, in net terms, have shown little change since the last Statement (Graph 53). Three-month money market rates rose in March as market participants revised upward their expectations for further tightening in monetary policy in the light of indicators of stronger economic activity. By late March, markets were expecting a rise in the cash rate, to 6½ per cent by mid year. Those expectations were significantly reduced following the release of the lower-than-expected March quarter CPI figures in late April. The market currently expects around a 50 per cent chance of a tightening of monetary policy by the end of the year.

Long-term interest rates have also fluctuated but shown little net change since the last Statement (Graph 54). Those on 10-year nominal bonds are now around 5.8 per cent, despite having initially fallen to 5.6 per cent in early March. While developments in US markets continued to have the major influence on local yields, the relative strength in domestic indicators has seen the spread between Australian and US yields widen to around 120 basis points from around 100 basis points at the time of the last Statement.

Yields on inflation-indexed bonds are also unchanged in net terms since early February, with implied inflation expectations remaining a little above 3 per cent. Yields on inflation-indexed bonds have in recent years been lower than they otherwise would have been due to the lack of new issuance and institutional factors which have boosted demand. This has reduced the usefulness of these yields in providing information about movements in inflation expectations.

Market perceptions of corporate credit risk have been broadly unchanged over the year so far and generally remain low (Graph 55). However, the premia on credit default swaps (CDS) – which are financial derivatives that provide insurance against defaults on corporate debts – for companies that are leveraged buyout targets have been volatile and remain at elevated levels. This reflects the likelihood that the debt-servicing burden of the bought-out company would increase, thereby increasing the default risk.

The generally low level of corporate bond spreads and CDS premia in part reflects low default rates in Australia and globally. In Australia, the most recent default of a rated corporate bond occurred in mid 2004, while the global speculative-grade default rate, at less than 2 per cent in April, remains close to its historical low (Graph 56). Changes to corporate credit ratings also indicate that credit quality generally remains high in Australia; Standard and Poor's announced more upgrades than downgrades in the March quarter. This is a continuation of last year's positive rating experience, and is favourable compared with history and on a global basis. In recent months, Standard and Poor's upgraded the four major banks, citing stronger risk management and very good asset quality.

Market perceptions of the quality of Australian sub-prime RMBS do not appear to have been affected by the recent stress experienced in the US sub-prime lending sector (see the ‘International and Foreign Exchange Markets’ chapter). Sub-prime loans in Australia are offered by a few specialist non-deposit taking lenders and account for just 1 per cent of all outstanding mortgages compared with 15 per cent of outstanding mortgages in the US. Subsequent to the developments in the US, $1.4 billion of Australian sub-prime RMBS have been issued, with one-third of these loans in the underlying mortgage pools to people with a documented record of loan default. Strong demand from investors meant that these RMBS issues were oversubscribed and sold at spreads that were low relative to initial expectations and history.

The share of Australian sub-prime loans in arrears has risen in recent years to around 6 per cent in early 2007, less than half the equivalent arrears rate on sub-prime loans in the US. To date, these arrears have not resulted in any losses to RMBS investors as defaults have been covered by property sales and securitisation vehicles' profits.

Intermediaries' interest rates

Most financial intermediaries' variable housing loan indicator rates have not changed since the time of the last Statement, consistent with there having been no change in the cash rate (Graph 57). After taking into account interest rate discounts, which are now received by almost all borrowers, the average actual variable housing rate paid by new borrowers is currently 7.45 per cent.

The five largest banks' average 3-year fixed rate on housing loans is also around 7.45 per cent, 15 basis points higher than at the time of the last Statement, although two major banks are currently offering discounts of up to 20 basis points on their 3-year fixed rate loans. The share of owner-occupier loan approvals that are at fixed rates has been stable at around 20 per cent over the three months to February (the latest data available). The higher-than-average share of housing loan approvals at fixed rates reflects a combination of borrower concern about the prospect of further rises in interest rates, fixed rates having been lower than variable rates and increased competition between banks to supply fixed-rate loans.

Over the past few months, several schemes have been launched by state governments and financial institutions to help first-home buyers (mainly those with low incomes) purchase a dwelling. These have been established either as shared-appreciation loans, where the lender receives a share of any capital gains or losses on the dwelling in lieu of interest, or as shared-equity schemes, where another party, usually the sponsoring institution or a friend or relative of the owner-occupier, separately owns and finances a share of the dwelling.

Competitive pressures continue to be evident in the business loan market (Graph 58). Despite the 25 basis point increase in the cash rate in November, the weighted-average interest rate paid on large variable-rate business loans rose by only 5 basis points in the December quarter (the latest period for which data are available). Over the whole of 2006, the weighted-average interest rate rose by 35 basis points, about half the 75 basis point increase in the cash rate. In contrast, the weighted-average interest rate on small variable-rate business loans rose by 20 basis points in the December quarter, and by 65 basis points over the whole of 2006.

The average 3-year fixed rate on small business loans was little changed over the past quarter at 8.2 per cent (Graph 59). The 3-year bank swap rate, which approximates the cost of funding these loans, was unchanged over the period.

Equity markets

The ASX 200 has continued to outperform overseas share markets, rising by almost 10 per cent so far this year (Graph 60). This follows four consecutive years of very strong returns, and three consecutive years of outperformance. The rise in the share market has been broadly based, as was the case in 2006.

Following the turmoil in overseas share markets in late February (described in the ‘International and Foreign Exchange Markets’chapter), the ASX 200 fell almost 3 per cent – the largest fall in a day since September 2001. The decline, however, proved to be short-lived and the share market quickly regained the losses experienced in late February/early March. It is now about 10 per cent above the trough reached in early March, having recorded successive highs over the past month or so.

Share prices have been supported by strong profit reports – around two-thirds of those ASX 200 companies that reported recently had stronger-than-expected profits. Underlying profits for reporting companies (which exclude significant items such as write-downs and gains and losses from asset revaluations/sales) were 26 per cent higher in the December half-year than in the corresponding period of 2005. While the growth rate in the resource sector moderated, growth in underlying profits of other companies accelerated. Nevertheless, resource companies' underlying profits increased by around 40 per cent, while the financials sector reported underlying profit growth of 22 per cent. For the banking sector, the profit outcome reflected strong balance sheet growth and restrained growth in costs which were partially offset by falling interest margins.

Recent takeover activity, both announced and speculated, has probably also provided support to equity prices. The value of merger and acquisition (M&A) activity in 2006 was relatively high, at about 10 per cent of the capitalisation of the local share market, although still below that in the late 1980s and in 2001 (Graph 61). This buoyancy has continued into the first few months of 2007, with around $80 billion of deals announced so far. Leveraged buyouts (LBOs) have accounted for much of the M&A activity in 2007 to date, with $37 billion of LBOs announced. The cumulative value of LBOs announced since the start of 2006 is $61 billion, which is equivalent to 3 per cent of the Australian non-financial corporate sector.

Analysts expect the earnings of resource companies to grow by 21 per cent in 2006/07. While growth in resource companies' earnings is expected to slow over the next couple of years to 7 per cent in 2007/08 and 3 per cent the following year, this still leaves the level of earnings per share at an historically high level. Growth in financials' and other companies' earnings are forecast to be broadly steady, averaging about 7–10 per cent per year, over the next three financial years (Graph 62).

The P/E ratio – the ratio of share prices to actual earnings per share – continues to be close to its historical average after taking account of the latest profit results (Graph 63). The forward P/E ratio – which is calculated using forecast earnings for the next financial year – is also close to average. The dividend yield remained at 3.5 per cent in April, slightly below its post-1987 average of 3.8 per cent.

Financing activity

Intermediated financing

Credit growth has picked up in recent months, following a period of moderation in the second half of 2006; credit growth was around 15 per cent over the year to March (Table 9). The recent pick-up in growth mostly reflects developments in business credit (Graph 64). Growth in borrowing by both unincorporated and incorporated entities has been strong, with the latter boosted by the recent significant increase in debt-funded mergers and acquisitions activity.

The demand for funds associated with LBO activity is starting to have an impact on the syndicated lending market. In the March quarter of 2007, $28 billion of syndicated loans were approved, of which around a quarter were used to fund LBOs (Graph 65). Some of these loans are now being bought by institutional investors; this is common practice in the US and Europe.

Also in line with international developments, ‘covenant-lite’ packages for the senior debt funding have become more common in the Australian LBO market. Covenant-lite loans pay a slightly higher interest rate in return for fewer loan covenants (such as maximum debt-to-earnings multiples and minimum loan amortisation rates). These funding arrangements allow the bought-out company greater flexibility in meeting debt obligations, but increase the credit risk for lenders. Overall, however, as discussed in the latest Financial Stability Review, Australian banks' exposures to leveraged loans remain small.

After slowing over the second half of 2006, housing credit growth appears to have steadied in recent months. Housing credit increased by around 3 per cent over the three months to March, a little faster than over the three months to December, and broadly in line with early 2006. Credit growth to owner-occupiers has stopped slowing, while investor credit growth has picked up slightly (Graph 66). Similar patterns have also been seen in new loan approvals to owner-occupiers and investors.

Personal credit grew by 12 per cent over the year to March, up from rates of around 10 per cent during the first half of 2006. Within personal credit, growth in margin lending for the purchase of shares and managed funds grew by 8 per cent in the March quarter to $30 billion (Graph 67).^[1] Over the year to March 2007, margin lending has risen by 41 per cent, driven by large increases in both the number of loans and the average loan size. Indicators of the riskiness of borrowers' margin loan positions, such as the average gearing level, were little changed in the March quarter and remain low by historical standards.

Non-intermediated financing

Net issuance of bonds by Australian non-government entities increased in the March quarter to $24 billion, around the average level recorded over the past few years (Table 10). The pick-up largely reflected an increase in net issuance by non-financial corporates and asset-backed vehicles. While a large share of non-financial corporate net issuance was offshore, this mostly reflected strong raisings by a couple of large companies. Offshore issuance continued to be supported by favourable conditions in currency swap markets that made it attractive to raise bonds offshore in foreign currency and swap into Australian dollars.

Non-residents' issuance of A$ bonds in the domestic bond market – kangaroo bonds – remained strong in the March quarter, continuing the trend seen over recent years. The outstanding value of these bonds totals over $100 billion (Graph 68).

Net non-intermediated capital raisings – debt, hybrids and equity – by the Australian non-government sector were $48 billion in the March quarter, up slightly from the average of the previous year (Graph 69). Net raisings by non-financial corporates have picked up recently, after being relatively subdued over the first half of last year. This mostly reflects strong bond issuance, as discussed above, although their non-IPO equity raisings have also picked up.

Footnote

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