Statement on Monetary Policy – May 20241. Financial Conditions

1.1 Interest rate markets

Most advanced economy central banks have signalled the next move in policy rates is likely to be down but are waiting for further evidence that inflation is declining sustainably towards their targets.

Most advanced economy central banks have held their policy rates unchanged since the February Statement at levels they assess to be restrictive. While most have also indicated that policy rates are likely to have peaked, central bank communications about the likely timing of policy rate decreases have become more divergent, reflecting differing progress on lowering inflation (see Chapter 2: Economic Conditions). A small number of central banks, including the European Central Bank, have discussed decreasing their policy rates around midyear and the Swiss National Bank has already reduced its policy rate. By contrast, several US Federal Reserve (Fed) officials have indicated that it may take longer to achieve the economic conditions necessary to warrant cuts to the Fed’s policy rate after stronger-than-expected US inflation data since the start of the year.

Market participants have scaled back expectations of the timing and extent of policy easing by most advanced economy central banks, though generally by less than for the United States (Graph 1.1). The strength of US inflation and labour market data has supported a shift up in expected policy paths globally, albeit to a lesser extent than the expected US policy rate path. This widening gap to US expectations for most economies reflects more favourable inflation outcomes in other advanced economies and the divergent central bank commentary about the policy outlook.

Meanwhile, the Bank of Japan (BoJ) raised its policy rate and announced an end to its yield curve control and several of its asset purchasing programs in March. In doing so, the BoJ cited increasing confidence that it will be able to sustainably achieve its inflation target after having had very low inflation for many years. Despite this tightening, Japanese Government bond yields remain well below the levels of other advanced economies and the Japanese yen has continued to depreciate.

Market pricing implies that there may be one further rate increase in Australia with policy easing later than previously anticipated.

In Australia, market participants’ expected path for the policy rate has also shifted up materially since the February Statement. Expectations for the cash rate rose in response to stronger-than-expected Australian inflation and labour market data. As is the case in other economies, a reassessment of the outlook for the policy rate in the United States also contributed to a revision to expectations in Australia (Graph 1.2).

Market pricing implies that the cash rate is not expected to be reduced over the coming year. Indeed, market pricing points to around an even chance of one further increase in 2024, with cuts in the cash rate seen as likely to take place in 2025. Market participants expect fewer cuts in Australia, and for these cuts to begin later than in many other advanced economies. But in coming years the cash rate is expected to converge to a similar level to the policy rates in several other advanced economies, where rates are currently higher. On average, market economists expect the RBA to begin cutting the cash rate a little earlier than implied by market pricing – in either the December quarter of this year or the March quarter of 2025 – although some market economists have also noted the possibility of a rate increase in coming months.

Government bond yields in advanced economies have increased in line with market expectations of a more gradual reduction in central bank policy rates.

The increase in government bond yields in advanced economies has generally been largest in the United States, consistent with the adjustment in policy rate expectations (Graph 1.3). The increase in yields predominantly reflects a rise in real yields, amid stronger-than-expected US inflation and labour market data (Graph 1.4). The increase in real yields across advanced economies also partly reflects higher term premia, which is the additional yield that investors demand to hold longer-duration securities.

Yields on Australian Government bonds have increased by a similar amount to those in many other advanced economies, but by a little less than US Treasury yields. Longer term inflation expectations inferred from government bond markets have risen by less in Australia than elsewhere and overall remain consistent with the RBA’s target band (see Chapter 2: Economic Conditions).

The Australian dollar TWI remains in the range observed since early 2022.

The Australian dollar is little changed against the US dollar and has appreciated on a TWI basis since the February Statement (Graph 1.5). This appreciation of the TWI has been largely driven by broad-based weakness in the Japanese yen; Japan is Australia’s second-largest trading partner. Nonetheless, the Australian dollar TWI remains around early-2022 levels, which is when global central banks began raising their policy rates. Based on historical relationships, the level of the Australian dollar (in real TWI terms) continues to be broadly consistent with model estimates implied by the forecast terms of trade and real yield differentials.

1.2 Other measures of financial conditions

While monetary policy settings in most advanced economies remain restrictive overall, several other measures of global financial conditions have eased since late 2023.

Equity prices remain close to record highs despite having recently declined somewhat in many economies alongside higher government bond yields (Graph 1.6). The increase in equity prices since late 2023 in part reflects a decline in estimates of risk premia, particularly for small groups of large companies, and upward revisions to estimates of future earnings, mostly for large US technology companies. In Australia, the financial sector has contributed the most to the increase in the ASX 200 since late 2023, while IT and real estate equity prices have risen the most. Adjusting for inflation, the real total return (capital gains plus dividends) that investors in the Australian share market have received over the past year is around 5 per cent.

In the past month, corporate bond yields in the United States, Europe and Australia have increased somewhat as sovereign bond yields have risen (Graph 1.7). Even so, spreads on corporate bonds in Australia, Europe and the United States are narrower than they were in late 2023. The narrowing of spreads reflects expectations of a relatively benign credit outlook and strong investor demand.

Corporate bond issuance has increased in the past few months in the United States, Europe and Australia. Companies have been seeking to take advantage of strong investor demand, while market reports suggest US companies have brought forward issuance to avoid potential market volatility around the upcoming Presidential election. Bank credit growth remains positive but below pre-pandemic levels in the United States and Europe, with credit growth increasing slightly in Europe since reaching a trough late last year. Lending surveys suggest that the tightening in credit conditions slowed considerably in late 2023 in the United States and in the past few months in Europe, which has historically been associated with strengthening economic activity.

Chinese financial conditions remain moderately accommodative.

Chinese Government bond yields have declined alongside further monetary easing (Graph 1.8). The People’s Bank of China guided banks to lower the five-year loan prime rate – a key mortgage lending reference rate – by 25 basis points in February. Overall, monetary policy easing has been more gradual than in past cycles as authorities continue to balance a desire to support growth against a need to contain longer term financial risks. This includes the risk of an excessive build up in private sector leverage as has occurred in past easing phases. Nonetheless, market participants still expect some further monetary easing.

Growth in total social financing has slowed further, although it remains in line with the authorities’ target. Chinese authorities have continued to provide guidance to banks to lend to priority sectors, including through the purchase of government bonds to support fiscal spending. Household credit growth has remained subdued over recent months, amid weak consumer sentiment and ongoing stress in the property sector. Many property developers remain under severe financial stress despite recent support, including authorities directing banks to lend to specific ‘white-listed’ projects to support completions. If stresses in the Chinese economy and financial system were to intensify or broaden, these could spill over to the rest of the world (including Australia). However, a recent pick-up in growth and equity prices may alleviate some of these concerns in the near term (see also Chapter 2: Economic Conditions).

The renminbi has depreciated against the US dollar over recent months, alongside other emerging market currencies in Asia and elsewhere (Graph 1.9). Market expectations of further monetary policy easing by Chinese policymakers alongside expectations that the US Fed policy rate will now be reduced later than previously anticipated have contributed to a widening of the interest rate differential between Chinese Government bond and US Treasury yields. Authorities have responded by setting the strongest ‘CNY fix’ – the midpoint of the permitted daily trading range of ± 2 per cent – for the renminbi since a survey of market expectations began in 2018. The renminbi has depreciated by around 1 per cent against the Australian dollar in the past three months.

1.3 Australian banking and credit markets

Wholesale funding market conditions remain favourable for financial institutions.

While bank bond yields have increased, spreads relative to the swap rate – a reference rate for the pricing of securities – have narrowed in recent months. This narrowing is more noticeable for the non-major banks (Graph 1.10). Banks have reported that there is less need to raise funds offshore because of favourable conditions in the domestic market. Conditions in the asset-backed securities (ABS) market have been similarly strong, with issuance in the first four months of the year at a post-GFC high, driven by non-bank lenders. Spreads for ABS have narrowed to be around pre-pandemic levels, with spreads for riskier tranches having narrowed by more than those for higher rated tranches.

Banks are well placed to repay funds from the RBA’s Term Funding Facility (TFF) by midyear.

The TFF was announced in March 2020 as part of the RBA’s policy response to the COVID-19 pandemic. Under the TFF, the RBA provided $188 billion of funding, of which $100 billion has matured, with the remaining $88 billion to mature by midyear (Graph 1.11).^[1] Banks have prepared for these maturities by prefunding; the value of bonds issued by banks in 2023 was a decade high and banks have increased the share of term deposits in their funding mix by around 5 percentage points over the past 18 months or so. Banks’ liquidity ratios are also well above regulatory minimums because some of the funding raised via bond issuance is being used to purchase additional High Quality Liquidity Assets.^[2]

Banks have also been adjusting their use of shorter-term debt to minimise rollover risk around the time of the TFF maturities. Partly reflecting this, the six-month bank bill swap rate (BBSW) to overnight indexed swap (OIS) spread has widened both in absolute terms and relative to three-month BBSW (Graph 1.12). This widening in spreads is similar to that experienced last year when the first tranche of the TFF was due. Remaining TFF maturities are larger, will be repaid over a shorter period and the supply of Exchange Settlement balances is now lower than when the first tranche matured. All of this increases the risk of a tightening in domestic money market conditions relative to the first tranche, though this risk still appears modest.

Banks’ funding costs are little changed recently, although over the tightening phase higher funding costs have weighed on banks’ net interest margins.

The TFF maturities marginally increase banks’ funding costs. The TFF maturities add to bank funding costs because it involves replacing low-cost funding with other more expensive sources. However, the impact is small because the TFF only accounts for a small share of banks’ overall funding and some of this funding was hedged, so part of the impact has already flowed through to funding costs.

Banks’ funding costs have been little changed in recent months, though they have risen substantially over the tightening phase. In turn, this has mostly been passed through to lending rates.

• Banks’ estimated funding costs have increased by around 370 basis points since May 2022, alongside the 425 basis points increase in the cash rate over the same period.
• Banks’ lending spreads have narrowed over this period because funding costs have increased by more than the increase in lending rates. Lending rates have increased by around 345 basis points (the pass-through of monetary policy to lending rates is discussed further below).
• This narrowing in lending spreads has weighed on banks’ net interest margins (NIMs), which are a little below their pre-pandemic level (Graph 1.13). Banks have cited increasing mortgage competition, higher wholesale funding costs and changes to their funding mix towards products that attract higher rates as some reasons for the decline in NIMs.

Overall financial conditions in Australia are restrictive, most notably for households.

The tightening of monetary policy has led to a significant rise in housing lending rates and scheduled household debt payments:

• Housing lending rates have increased by around 335 basis points over the tightening phase (Graph 1.14). As was broadly expected, pass-through to housing rates has been somewhat slower than in some previous episodes of tightening. This is because of the high share of mortgages fixed at low rates during the pandemic. In addition, there has been increased mortgage discounting by lenders amid strong competition for borrowers. Most of the remaining low fixed-rate loans from the pandemic era will expire this year. As these loans roll over to higher variable rates, it will add around 20 basis points to the average overall outstanding mortgage rate over the rest of 2024.
• Scheduled principal and interest payments for mortgages are at a historically high share of household disposable income (Graph 1.15). Even so, total household debt payments (including estimated repayments on consumer credit) remain slightly below the estimated 2010–2011 peak when the cash rate reached 4.75 per cent, because of a significant decline in the use of consumer credit since 2008.

The rise in household debt payments has put pressure on household budgets and contributed to the weakness in consumption growth (see Chapter 2: Economic Conditions). Despite budget pressures, nearly all borrowers (around 40 per cent of households have a mortgage) continue to service their debts on schedule. Most borrowers are expected to be able to service their debts and meet essential living expenses even if inflation is more persistent than anticipated and interest rates remain high for some time.^[3]

Higher interest rates also provide an incentive for all households to save more. Consistent with this, households with mortgages are overall contributing a little more to their offset and redraw accounts than mid-last year. These payments are now a bit above their pre-pandemic average. In aggregate, despite cost-of-living pressures and higher household debt payments, the (gross) savings rate is around pre-pandemic levels; consistent with some households making extra mortgage payments, the savings rate has picked up since mid-2023 (Graph 1.16).

Household credit growth has been subdued in the face of higher interest rates. Housing and personal credit growth have increased from around mid-2023 but remain low after accounting for inflation (Graph 1.17). New housing lending has increased over the past year, but this has had only a limited impact on housing credit growth as it has occurred at the same time as an increase in loan discharges. The share of credit card balances accruing interest declined over the March quarter and is at historically low levels, suggesting households in aggregate are not turning to personal credit in response to cost-of-living pressures.

Tighter borrowing constraints have also affected the composition of new lending. Throughout the tightening phase, the average loan-to-value ratio (LVR) for new mortgages has declined and the average income and deposit size for borrowers have increased (Graph 1.18). This suggests that some borrowers – particularly those with lower incomes and with less wealth – are constrained by how much banks are willing to lend in response to higher interest rates. Also, households’ abilities to take on debt is weaker in the face of higher debt-servicing costs. Banks reported a further tightening in household credit conditions in the December quarter last year, and most banks expected mortgage serviceability requirements to remain at current levels or tighten over the next 12 months.

Increases in the cash rate have caused a tightening in financial conditions for businesses overall …

The tightening in monetary policy has led to an increase in business lending rates, corporate bond yields and interest expenses. For many medium and large businesses, this has been buffered by strong financial positions and nominal earnings. Most listed companies hold cash buffers that are slightly higher than pre-pandemic levels and the debt-servicing capacity of listed businesses is around the post-GFC average.^[4] Although some indicators of financial stress among businesses have picked up recently, many are still around or below historical averages.

… though this has had less effect on larger businesses with access to wholesale funding markets.

Although businesses are paying high rates to take out debt, business credit growth is slightly above its post-GFC average and larger firms have been raising funds from wholesale markets (Graph 1.19). Non-financial corporate bond issuance has been strong and investor demand has contributed to tighter spreads relative to AGS, particularly for lower rated businesses (though corporate bond yields are well above pre-pandemic levels). Consistent with the more favourable financial conditions for larger businesses, business investment growth has been strong, though it is expected to slow alongside the broader slowing in aggregate demand growth (see Chapter 2: Economic Conditions and Chapter 3: Outlook). As has been the case for many years, small businesses report that accessing funding through banks with terms that suit their needs remains a challenge.

Endnotes

For more information about the Term Funding Facility, see Black S, B Jackman and C Schwartz (2021), ‘An Assessment of the Term Funding Facility’, RBA Bulletin, September. [1]

For more information on banks’ liquidity ratios, see RBA (2024), ‘Chapter 3: Resilience of the Australian Financial System’, Financial Stability Review, March. [2]

For more information on household balance sheets, see RBA (2024), ‘Chapter 2: Resilience of Australian Households and Businesses’, Financial Stability Review, March. [3]

For more information on business indebtedness, see RBA, n 3. [4]