Reserve Bank of Australia Annual Report – 1986 The Bank's Market Operations

The Bank's operations in the domestic money and securities markets throughout the year were directed at maintaining firm, at times very firm, financial conditions.

There were three distinct phases. From July to October, the Bank sought about the same degree of firmness in financial conditions as had applied in the closing months of 1984/85. Interest rates drifted up by a percentage point or so over this period. Demand for credit was high. The second phase began in November when monetary policy was abruptly tightened; that tightness was maintained until late February. Short-term interest rates rose by around 3 percentage points over November/December. In the final four months of the year, there was some easing of financial conditions as demand for credit moderated and market interest rates fell, in many cases to levels below those of a year earlier.

In the foreign exchange market, the Bank did not go beyond its normal testing and smoothing operations. Nevertheless, its operations were relatively heavy during the first half of the year, particularly in the unsettled market conditions of November. With the exchange rate often under downward pressure, the Bank was a net seller of foreign currency, to the extent of US$626 million over the six months. Those operations were designed to test the strength of market pressures and, when necessary, to help the market through periods of difficulty and uncertainty; they did not aim to prevent movement of the exchange rate. For much of the second half of the year, the Bank's foreign exchange operations were more closely balanced between purchases and sales of foreign currency. In June, however, with markets unsettled, the Bank was again a net seller of foreign currency.

The Bank conducts its domestic market operations against the background of the Commonwealth Government's debt management activities, some of which are handled by the Bank as the Government's fiscal agent. Overseas, the Government's borrowing programme raised net $1.3 billion. Domestically, it raised funds through bond and Treasury note tenders. There were seven tenders for Treasury (non-indexed) bonds, spaced fairly evenly throughout the year. The face value of bonds issued, including through the associated tap arrangements, was $5.7 billion. An additional four tenders were held for Treasury indexed bonds, issuing a total of $0.3 billion. Treasury note tenders were conducted during most weeks of the year. These contributed to a net increase of $1.6 billion of notes in private hands. Sales of Australian Savings Bonds were not sufficient to offset heavy redemptions during the year and private holdings of these securities declined by $2.0 billion.

Treasury Bond and Indexed Bond Tenders^(a)

Tender Number	Date Held	Amount Allotted ($m)
Bonds
24	9 July 1985	900
25	27 August	800
26	8 October	700
27	26 November	751
28	14 January 1986	751
29	25 February	751
30	20 May	851
Indexed Bonds
1	30 July 1985	100
2	4 November	66
3	4 February 1986	75
4	6 May	75
(a) Excludes amounts raised through associated taps.

There were no major changes in institutional arrangements concerning the Bank's domestic market operations in 1985/86. The two changes in the previous year — the introduction of repurchase agreements and the reporting bond dealer arrangements — continued to play a useful role. The list of reporting bond dealers was reviewed in December 1985 to take account of market developments.

While the Bank's market management arrangements generally worked satisfactorily, there were occasions when smoother operations might have been possible with a more active market in short-dated Commonwealth Government securities, particularly Treasury notes. Although the private sector's holdings of Treasury notes increased by about $1.6 billion over the year, demand appeared to grow even more rapidly, in part because of new banks seeking to acquire assets for PAR purposes.

For short periods, secondary market trading was extremely thin and a wide disparity developed between yields on Treasury notes and those on private paper of similar term to maturity.

The foreign exchange market continued to grow quickly in 1985/86. On figures adjusted as far as practicable to remove double-counting, total turnover of all currencies in the Australian foreign exchange market roughly doubled in 1985/86. In the June quarter, average daily turnover in the market was around $16 billion compared with $7 billion in the same period a year earlier. Reflecting the establishment of new banks and merchant banks, the number of authorised foreign exchange dealers increased from 55 to 76 over the year. Requirements for authorisation have remained the same since new authorities were first granted in April 1984. In April 1986, the Bank extended its own foreign exchange dealing arrangements to provide for some transactions to be placed through foreign exchange brokers.

The Foreign Exchange Market Consultative Group — established by the Bank in early 1985 as a forum to consider issues affecting the operation of the market — submitted its first report in December 1985. Among matters covered were the need for a code of standards appropriate to the Australian market, the basis for settlements (gross or net) of foreign exchange transactions, and the use of originally-contracted exchange rates in forward contracts.

The year in detail^[*]

July–October

With the economy and money and credit aggregates growing strongly, the Bank sought, in the early part of the year, to restrain conditions in financial markets.

Although yields on securities fell for most of July, by the end of the month there were signs that this trend was being reversed as traders faced re-emerging uncertainties about the Australian dollar and little prospect of easier monetary policy.

After rising in July, the Australian dollar weakened through August and most of September. Sentiment in the foreign exchange market became adverse as indicators continued to show large current account deficits and fast growth in money and credit. With a weakening exchange rate and restraint in the Bank's market operations, domestic security yields increased over August and September by about one percentage point.

In October, increased nervousness became apparent in financial markets. The Australian dollar weakened in trade-weighted terms, reflecting unease in the market about monetary growth rates and the balance of payments. The Australian dollar struggled to hold its value against the U.S. dollar, even though the latter was depreciating against other major currencies. In domestic markets, the nervousness was most apparent in a rise in bond yields. Short-term interest rates were less affected, rising only marginally.

November–January

In early November, market sentiment deteriorated on news of a sizable increase in the rate of growth of broad money, the outcome of the National Wage Case and intimations of a likely fall in oil prices. The exchange rate fell in the first half of November to a low of 65.5 U.S. cents, from 70 cents at the start of the month (and almost 73 cents at end July). Against the trade-weighted index, it fell from 63.4 (68.5 at end July) to 59.2. The Bank was active in the foreign exchange market during this period to try to settle some of the more extreme instability.

Unsettled conditions in the foreign exchange market spilled over into domestic markets. Bond yields increased sharply, touching 15.7 per cent (on 10-year bonds). Yields on short-term securities rose to over 19 per cent.

The sharp deterioration in market sentiment in early November was exacerbated by a worsening outlook for the balance of payments. Accordingly, monetary conditions were tightened severely by the Bank. In its market operations the Bank sold heavily to absorb cash surpluses and was sparing in providing cash to the market. The average cost of funds paid by authorised dealers reached 18½ per cent by mid November, up from 16 per cent at the start of the month. Rates in the unofficial market were over 19 per cent. The Bank also increased frequently, at times daily, the Treasury note rediscount rate and the rate on central bank loans to authorised dealers, to take account of the sharp rises in market yields. While yields on marketable securities rose sharply, rates paid and charged by financial institutions were slower to respond.

In the second half of November, the exchange rate recovered some of the earlier fall. Market conditions were calmer and the Bank's operations in the foreign exchange market were much smaller. The more stable conditions continued into December. Domestic markets took some confidence from these steadier conditions in the foreign exchange market. Bond yields fell slightly, though yields on short-term securities drifted up as the effects of the tightening in November fed through the markets. There were also further increases in interest rates charged by financial intermediaries. In its domestic market operations, the Bank maintained the tighter approach it had adopted in the first half of November with the result that cash rates remained at the higher levels.

With the start of the new year, sentiment in both foreign exchange and domestic markets improved. The tightening in policy had helped cut credit demands and seemed to have reassured markets that growth in activity would be reined back to a more moderate pace. Falls in overseas interest rates also contributed to a more optimistic tone in domestic financial markets, increasing overseas demand for Australian securities and helping the exchange rate to appreciate. Domestic demand for securities also picked up as markets became more hopeful that a slowing in growth might allow some easing in policy. Yields on securities fell. However, economic and financial indicators were still mixed and, on balance, the Bank decided to continue during January and February the approach to policy that it had adopted in November.

February–June

By late February, there were increasing signs that growth of money and credit was slowing. There was also some evidence that growth of economic activity was slowing; this offered the prospect of reduced pressure on the balance of payments. Market yields continued to fall, aided by declines in interest rates overseas.

The Bank accepted that some decline in domestic interest rates was consistent with monetary policy. Its market operations reflected that view, and overnight and call interest rates declined by about 1½ percentage points over the closing days of February. The Bank also reduced the rediscount rate and the rate on central bank loans to dealers to take account of the fall in market interest rates.

These trends continued in March. The Australian dollar rose a little over the month, against both the U.S. dollar and the trade-weighted index. The Bank's foreign exchange market transactions during that month resulted in net purchases of foreign currency, in contrast to the net sales of earlier months. Interest rates continued to fall. By the end of March, short-term interest rates had returned to the levels before the November increases. Bond yields, reflecting strong demand locally and from overseas, had fallen well below pre-November levels and were at their lowest for about five years. Some financial intermediaries reduced their interest rates.

The fall in interest rates was arrested and partly reversed for a time in the first half of April as the market came under pressure as a result of tax payments. Although maturing government securities provided some offset to these tax payments, the ability of the Bank to accommodate the remaining shortage of funds was constrained by a reluctance of some holders of Treasury notes and short bonds to sell in an environment which seemed to promise them further capital gains if they held their portfolios. Pressures were felt mainly in the unofficial market, with the result that there was an unwelcome widening in the gap between official and unofficial cash rates. However, these pressures were short-lived and tax payments in early May were handled without strain, the Bank having arranged a substantial amount of repurchase agreements to be reversed in that period to provide cash to the market.

The Australian dollar was steady in trade-weighted terms in April, though it rose against the weakening U.S. dollar. The climb against the U.S. dollar continued in early May, with the exchange rate reaching a peak of almost 75 U.S. cents. However, following release of figures showing a larger-than-expected current account deficit in April, the Australian dollar fell sharply, going below 70 U.S. cents. Nervous conditions in the foreign exchange market persisted in June in the face of growing awareness and debate about Australia's longer-term economic problems. The exchange rate fell further to a little below 68 U.S. cents. Against the trade-weighted index, the Australian dollar ended the year at 56.3, a fall over the year of 13.4 per cent. Bearish sentiments continued into July and the exchange rate weakened further.

Interest rates, after falling in the first half of May, did not change much from mid May to end June. Cash rates during this period were close to 13 per cent in the official market and 14.5 to 15 per cent in the unofficial market; yields on 90-day bank bills were also around 14.5 to 15 per cent. In general, short-term interest rates at the end of June were 1 to 2 percentage points lower than a year earlier. Bond yields were about 13 per cent at the end of June, down a little from a year earlier. Some of the more market-sensitive interest rates of financial intermediaries ended the year lower than at the start but most rates paid and charged by financial intermediaries, having been more sluggish to rise were also more sluggish to fall, and ended the year higher.

At year's end, financial conditions were steady. Growth of demand for credit had moderated from the rapid pace set in the first half of the year. Domestic financial markets showed a good deal more stability than they did in the first half of the year but the foreign exchange market remained fragile.

The Bank's holdings of Commonwealth Government securities and foreign exchange

During 1985/86, the Bank's holdings of Commonwealth Government securities rose by $3.1 billion. The Bank's use of funds for this purpose may be seen in some degree as offsetting funds received from the net increase of $0.7 billion in the note issue, the increase of $0.4 billion in Statutory Reserve Deposit Accounts and the sale of $2.6 billion of foreign exchange reserves. The bulk of the increase in the Bank's portfolio reflected in Treasury note holdings, up $2.3 billion to $3.2 billion. Treasury bond holdings rose by $0.7 billion to $6.4 billion.

The major influence on the Bank's holdings of foreign currencies comes from transactions (purchases and sales) in the market and with customers, predominantly the Commonwealth Government. However, the various currencies are invested in appropriate high quality liquid assets, largely short-term obligations of governments, and the interest received on these investments can be substantial. For balance sheet purposes, the foreign currency holdings are amalgamated at their current value in Australian dollars. Consequently, any variation in the exchange rate for the Australian dollar against the other currencies affects their published value.

In 1985/86, the Bank's foreign exchange transactions with the market reduced its holdings by a net $1.0 billion; transactions with the Commonwealth Government (sales less purchases of loan proceeds) produced a further reduction of $1.6 billion; interest received on investments was $0.6 billion; and net currency revaluations added $1.3 billion. Together with some minor influences, these factors led to a net fall in the Bank's foreign currency holdings, valued in Australian dollars, of $0.8 billion to a level of $8.7 billion.

For some years, the bulk of the Bank's holdings of foreign currencies has been in U.S. dollars. That changed in 1985/86; U.S. dollar holdings fell below holdings of all other currencies combined. Partly this was due to the relative depreciation of the U.S. dollar, but it also reflected the nature of the Bank's transactions. Purchases from the Government, mainly the proceeds of overseas borrowings, were largely in currencies other than the U.S. dollar. Sales, both to the Government and to the market, were mostly in U.S. dollars. In re-arranging its portfolio, the Bank converted other currencies into U.S. dollars, but not to the extent of offsetting all these influences.

Footnote

Quarterly articles on the Bank's market operations during 1985/86 appear in the November 1985, February, May and August (forthcoming) 1986 issues of the Bank's Bulletin. [*]