Statement on Monetary Policy – February 2010 Domestic Financial Markets

Money markets and bond yields

The Board increased the cash rate target in December, to 3.75 per cent, and left it unchanged at the February meeting. Money market yields continue to reflect expectations of further tightening, though at a slightly slower pace than at the time of the previous Statement. The cash rate is expected to reach around 4½ per cent by the end of the year.

The spread between bank bill yields and the expected cash rate remains close to its level at the start of November, which is above its pre-crisis level but below the average during the financial turmoil (Graph 58). In December this spread was more volatile. This volatility appears to reflect some decline in the liquidity of the bill market, particularly around year-end, rather than any resurgence of concerns about bank counterparty risk.

In its market operations, the Bank has responded to changing demands for cash balances from commercial banks. Partly reflecting year-end pressures and higher demand for borrowing cash on a secured basis, the Bank allowed Exchange Settlement (ES) balances to rise temporarily in late December and early January. Aggregate ES balances have since fallen and are currently around $1½ billion.

Yields on 10-year Commonwealth Government Securities (CGS) have fallen by about 10 basis points over the past few months, with the spread to US Treasuries narrowing by about 30 basis points to 180 basis points (Graph 59). There have been larger falls in the yields on shorter-maturity CGS. Issuance of CGS slowed in recent months as the Australian Office of Financial Management (AOFM) did not conduct tenders over the year-end period. Nevertheless, total CGS outstanding has increased by around $11 billion since the last Statement to $121 billion. In early November, the Government's Mid-Year Economic and Fiscal Outlook revised down projected issuance in future years so that the outstanding stock is projected to peak at $270 billion, almost $50 billion less than previously anticipated.

Spreads at which state government bonds (semis) trade over CGS have narrowed slightly over the past few months, declining to around their previous lows of September 2009 (Graph 60). Semi issuance has been sizeable with one state that had previously used the Australian Government guarantee issuing without this, as it was cheaper to issue unguaranteed debt and there was good market access. At $4 billion, the bond was equal to the largest ever issued in Australia. Spreads on supranational debt remain around the elevated levels seen at the end of October, partly reflecting the strong issuance of Kangaroo bonds (bonds issued domestically by non-residents).

Financial intermediaries

There has been little change in the composition of banks' funding over recent months. The share of funding from deposits has remained at around 43 per cent in the December quarter after rising during 2008 and early 2009 (Graph 61). The shares of funding that come from domestic and foreign long-term capital market debt and equity have increased slightly over the quarter as banks continue to manage their balance sheets conservatively. Banks' use of short-term capital market debt has contracted further.

Competition among financial intermediaries for deposits remains intense, with the average rate on new at-call deposits (including online savings, bonus saver and cash management accounts) rising by over 80 basis points since end October, to be now higher than the cash rate (Graph 62). The average rate on the major banks' existing at-call deposits has risen by almost 60 basis points over the same period with the margin below the cash rate on these accounts the lowest it has been.

The average rate on the major banks' term deposit ‘specials’, the most relevant rate for term deposit pricing, has risen by nearly 75 basis points since end October, and is up about 240 basis points since early 2009. For the past few months, the major banks have offered higher interest rates on 3- and 5-year term deposits than they pay on bonds of equivalent maturity, with this gap recently around 80 basis points for 3-year funds (Graph 63).

Australian banks issued $230 billion of bonds in 2009 – nearly double the issuance in 2008 and well above issuance in prior years (Graph 64). The very strong issuance last year predominantly reflected banks seeking to increase the duration of their wholesale funding liabilities as they shifted out of short-term debt. Australian banks have continued to lengthen the maturity of their liabilities by issuing longer-dated bonds. The average tenor of bonds issued recently is 4.8 years, up from 3.9 years a year ago.

Since the previous Statement, banks' bond issuance has amounted to around $58 billion, with the banks continuing to access a diverse range of markets and currencies. About 80 per cent of issuance has been offshore. Notwithstanding occasional issues of guaranteed bonds, the banks have increasingly issued unguaranteed bonds in recent months as investors have again become comfortable holding bank credit risk. Over the past few months, around two-thirds of newly-issued bank bonds have been unguaranteed, the highest share since the Australian Government Guarantee Scheme was introduced in October 2008 (Graph 65).

Unguaranteed issuance continues to be underpinned by the major banks for whom unguaranteed debt funding is generally cheaper than guaranteed debt. Nevertheless, there have been some guaranteed issues by major banks in recent months – notably in December – when it has been cost effective to do so and in response to reverse enquiries from investors. Secondary market spreads on guaranteed and unguaranteed bonds issued domestically by the major banks have narrowed a little since the previous Statement, and are well below their peak in early 2009 (Graph 66). Overall, yields on the major banks' bonds have fallen since the previous Statement.

The cross-currency basis swap – which represents an additional funding cost for banks from hedging foreign currency bond issuance into Australian dollars – increased substantially over the final quarter of 2009. The cost of hedging 5-year US dollar issuance has increased by around 25 basis points since September 2009, to 45 basis points, with the cost of hedging bonds denominated in other currencies increasing by a similar amount (Graph 67). Market reports have attributed the pick-up in the cross-currency basis swap to an expected increase in Australian banks' bond issuance offshore, which would increase demand for this hedging instrument. However, the cross-currency swap market is relatively illiquid, with large irregular flows, and has exhibited large changes and reversals over the past couple of years. The elevated cross-currency basis swap has given Kangaroo issuers an incentive to tap the Australian market, with issuance picking up significantly in recent months. This Australian dollar issuance that non-resident issuers hedge into foreign currencies, in turn, puts downward pressure on the cross-currency basis swap.

Conditions in Australian securitisation markets have improved significantly over the past few months. Five residential mortgage-backed securities (RMBS) amounting to $5.3 billion have been issued since the previous Statement (Graph 68). Four of these deals, amounting to $4.8 billion, were issued without the AOFM as a cornerstone investor, including the first issue by a major bank since May 2007. These issues were met with strong demand from investors, including international investors, and tended to be upsized. Less than 10 per cent of issuance during the December quarter was purchased by the AOFM, down from around 80 per cent over the first half of 2009.

While issuance has picked up, this has not been large enough to offset the ongoing amortisation of principal (i.e. mortgage repayments) and so the stock of RMBS outstanding has continued to decline. The value of Australian RMBS outstanding is currently around $90 billion, almost 50 per cent below its peak in June 2007. RMBS outstanding offshore has declined by more than 60 per cent, because there has been no offshore issuance, while paper outstanding onshore has fallen by almost 30 per cent. The AOFM's holdings amount to around 8 per cent of all Australian RMBS outstanding, and 14 per cent of the domestic market.

The pick-up in investor demand for RMBS has also been reflected in declining spreads on deals issued without the AOFM as a cornerstone investor. The AAA-rated tranches of the most recently issued RMBS without the support of the AOFM priced at spreads of 130–135 basis points above BBSW, around 15 basis points below the spread on the first such deals in September. While RMBS spreads remain high by historical standards, recent issues were likely to have been profitable for the issuers.

Spreads on AAA-rated RMBS tranches trading in the secondary market have, on average, narrowed over the past few months. Over the past year, there has been a substantial narrowing in the gap between secondary and primary market spreads, suggesting that the market has worked through much of the overhang of supply created by the portfolio liquidation of structured investment vehicles (SIVs). Prior to the financial crisis, these entities accounted for around one-third of the investor base.

Conditions in the Australian securitisation market continue to be supported by the relatively high quality of collateral underlying securities. Losses on Australian RMBS (after proceeds from property sales) remain low as a share of the stock outstanding, at 8 basis points per annum for prime and 150 basis points for non-conforming RMBS. Moreover, the bulk of losses continue to be covered by credit enhancements, including lenders' mortgage insurance, and the profits of securitisation vehicles. No losses have been borne by investors in a rated tranche of an Australian RMBS.

Conditions in short-term securitisation markets have also improved. While the amount of asset-backed commercial paper (ABCP) outstanding continues to fall, market participants report that they now have little difficulty rolling over paper, including at longer maturities. The decline in the stock of ABCP outstanding reflects the ongoing amortisation of existing loan pools (i.e. loan repayments) as well as some reduction in the supply of assets typically funded by ABCP (such as lending by mortgage originators). The improvement in conditions has been reflected in declining spreads. Since their peak, spreads on ABCP have fallen by around 20 basis points to be around the same level as in January 2008, at 45 basis points.

Household financing

On average, variable interest rates on prime full-doc loans (after discounts) have risen by about 60 basis points to 6.07 per cent since end October, though there was some variation across individual lenders (Table 8). For the major banks, the range of their standard indicator rates on housing loans has widened over the past two years, to 27 basis points. Previously, the rates charged had been very tightly clustered.

The major banks' interest rates on new 3-year and 5-year fixed-rate housing loans have risen by around 10 basis points since end October. With fixed rates currently around 1½–2 percentage points higher than variable rates, the share of owner-occupier loan approvals at fixed rates has declined further to 3 per cent.

Preliminary evidence suggests that the value of housing loan approvals experienced a sizeable fall in December, following declines in October and November. Loan approvals to first-home buyers have fallen since mid 2009 as mortgage rates have risen and the government incentives were wound back. Approvals to non-first-home buyer owner-occupiers also appear to have fallen recently, although investor approvals have continued to grow. The five largest banks' share of gross owner-occupier loan approvals stabilised during 2009 at about 82 per cent, up from 60 per cent before the onset of the financial market turbulence in mid 2007 (Graph 69). The market shares of the smaller banks, credit unions and building societies and wholesale lenders were little changed over 2009.

Housing credit growth has continued at a monthly average pace of 0.7 per cent in the December quarter (Graph 70). While owner-occupier housing credit has been the main driver of growth over the past year, lending to investors has started to pick up in recent months.

Financial institutions' rates on variable personal loans have risen by an average of 59 basis points since end October. Average variable rates on unsecured personal loans and margin loans have increased by 50–55 basis points, while rates on home equity loans and credit cards have risen by 60–65 basis points.

Personal credit, which is a small component of household credit, rose at a monthly average pace of 0.5 per cent during the December quarter. Within that, margin lending has remained broadly stable throughout 2009, having roughly halved during the previous year. More favourable conditions in equity markets meant that the incidence of margin calls remained low at less than one call per day per 1,000 clients during the December quarter, while borrowers' gearing levels were little changed.

Business financing

Since end October, the major banks have raised their variable indicator rates on small business lending by around 50 basis points, while indicator rates on 1–5 year fixed-rate facilities have fallen by 5–30 basis points.

Variable interest rates on banks' outstanding large business loans (those greater than $2 million) are estimated to have increased by an average of 57 basis points since end October to 6.04 per cent (Graph 71). This reflects rising money market rates and a small increase in average risk margins as outstanding loans are gradually repriced at the current higher spreads. The average rate on new lending is estimated to have risen by about 40 basis points.

The changing composition of business external funding continued in the December quarter 2009, with declines in business credit offset by increases in non-intermediated debt (largely bond issuance) and new equity raisings (Graph 72). In large part, the decline in business credit over the past year reflects the repayment of bank loans by listed corporates, mostly funded by equity raisings, with companies reducing their leverage. Corporates that continued to raise debt funding during 2009 tended to do so in non-intermediated markets, rather than through banks.

Over the December quarter, business credit fell at an annualised rate of 10.3 per cent, with the decline reasonably broadly based across industry sectors and evident for banks and non-bank lenders. The contraction in business credit over recent quarters has been more pronounced for large businesses than for small businesses.

Commercial loan approvals have been broadly steady throughout the year, following significant declines in 2008. There has been a pick-up in syndicated lending activity during the December quarter, with $23 billion of approvals to Australian businesses, substantially more than during each of the preceding four quarters. Much of the increase in syndicated lending has been attributable to capital expenditure and general corporate purposes, though refinancing continued to account for the largest share of lending.

Equity raisings remain the main source of business external funding, particularly for listed corporates. Already listed corporates (i.e. excluding IPOs) issued $15 billion of new equity during the December quarter, bringing issuance to a record $70 billion for 2009 (Graph 73). While companies are continuing to issue equity with the intention of retiring debt, an increasing number of companies have announced equity raisings to fund investment, including acquisitions. With the aggregate debt-to-equity ratio having declined by around 20 percentage points to around its long-run average of 65 per cent, it appears that many large listed companies may have completed their intended balance sheet adjustment.

Only a small number of listed corporates repurchased equity during 2009, with buybacks amounting to just $2 billion for the year – the smallest amount since 2002. Instead of using funds to repurchase equity, corporates have preferred to retain cash or retire debt given the uncertain outlook, though market reports suggest that buybacks are likely to pick up in the coming months. While IPO activity in 2009 was also relatively subdued, a couple of large companies listed on the ASX late in the year – the first IPOs of size for around 18 months – and some IPOs are currently in the pipeline.

Corporate bond issuance was solid in the December quarter with $6 billion raised. While the bulk of bonds were issued offshore by larger Australian entities, medium-sized real estate companies refinanced debt by issuing bonds into the domestic market. The broadening of issuers into the domestic market over recent months is another sign that investor risk aversion has eased from its extreme levels in early 2009. Consistent with this, spreads on corporate bonds have narrowed. BBB-rated corporate bonds are trading at around 300 basis points above CGS, 280 basis points below their peak in April 2009.

Aggregate credit

The average interest rates on all outstanding housing and business loans (variable and fixed) are estimated to have both increased by about 50 basis points since end October, to 6.50 per cent (Graph 74). For housing rates, this is about 45 basis points below its post-1997 average, though around the levels seen earlier in the decade. The rate for businesses has now risen by about 85 basis points since its early-2009 low, but is still about 70 basis points below its post-1997 average. Given the increases in banks' funding costs and lending spreads, both housing and business interest rates are closer to their historical averages than is the cash rate.

In aggregate, there was a small increase in total credit outstanding over the December quarter as the fall in business credit was more than offset by the growth in household credit. Over the year, total credit rose slightly (Table 9; Graph 75).

Equities

Over 2009, the ASX 200 increased by 31 per cent, its largest gain since 1993 (Graph 76). All sectors of the Australian share market recorded increases over the year.

Notwithstanding a 9 per cent fall in January, the ASX 200 is up slightly since the previous Statement. This is broadly in line with developments in share markets overseas (Graph 77). Resource stocks have risen on optimism about production volumes and higher commodity prices, though financials have been weighed down by uncertainties about the regulatory outlook in the United States. Share prices of other companies in the index have risen by around 3 per cent. The Australian share market remains around 30 per cent below its November 2007 peak and has seen little net change since September 2009.

Due to the fall in profits reported by listed companies in 2008/09 and the pick-up in the share market, the Australian trailing P/E ratio has risen sharply over the past year to stand at around 25 (Graph 78). While the trailing P/E is currently well above its historical average, this ratio tends to rise around the end of recessions as share prices incorporate the expected improvement in earnings. Incorporating these expectations, the forward P/E ratio – which is based on earnings forecasts for the next 12 months – is currently a little above its long-run average but not particularly high by historical standards.

The dividend yield for the Australian share market is around its long-run historical average. Since its peak in early 2009, the Australian dividend yield has nearly halved to 4 per cent, with around 45 per cent of this fall due to firms cutting dividends in order to retain cash. Reflecting the decline in uncertainty about the economic outlook and improving financial conditions, there has been a recent pick-up in M&A deals announced by listed entities. Deals amounting to $28 billion were announced during the December quarter 2009 – one of the larger quarterly amounts since 2000. Recently announced deals are being mostly funded by equity and companies' high levels of cash holdings rather than debt.