Statement on Monetary Policy – August 2006 Domestic Financial Markets and Conditions

Interest rates and equity prices

Money and bond yields

At the time of the last Statement – released a few days after the cash rate target was increased to 5.75 per cent in early May – short-term yields were trading broadly in line with the cash rate. In mid June, however, market yields began to rise in response to continuing signs of strength in the domestic economy and increased concerns about inflationary pressures (Graph 35). By late July, the level of short-term yields was consistent with the market having fully priced in a tightening in August. In the event, when the Bank did tighten in August, yields were unchanged.

Yields on long-term bonds in Australia have been rising since mid 2005. In recent weeks yields on 10-year bonds have been trading around 5.8 per cent, whereas in mid 2005 they were only a little over 5 per cent (Graph 36). During this period, there has been little net change in real yields on indexed bonds. Accordingly, the rise in nominal yields has been mainly a reflection of rising inflationary expectations.

The rise in long-term yields in Australia has been part of a general worldwide trend. In fact, yields in the US have risen more than in Australia, resulting in the spread between yields in the two countries narrowing from about 1 percentage point a year ago to about 85 points now.

Even though long-term yields have risen since 2005, for much of the past year they have remained below the level of short-term rates – i.e. the yield curve has been inverted (Graph 37). Traditionally, an inverted yield curve has been regarded as indicative of expectations of a slowing in the economy and falling short-term rates. In recent years, however, interpreting the slope of the yield curve has become problematic because it has been affected by factors other than the state of the economy, such as the relative scarcity of government bonds and the low level of overseas bond yields. While the yield curve does typically flatten or invert with the onset of an economic slowdown, it can also do so at other times. Over the past 15 years of uninterrupted economic growth, for example, the yield curve has been flat or inverted on a number of occasions.

In the corporate bond market there has been a small pick-up in credit spreads but they remain low (Graph 38). In part, this reflects the very low rates of corporate bond default being experienced in Australia and globally: in the first half of 2006 less than 2 per cent of global speculative grade issuers defaulted. This is around the lowest default rate seen in the past 20 years (Graph 39).

Also contributing to low spreads is the continued strong demand from domestic and non-resident investors for higher-yielding assets. Within the Australian corporate bond market, this has been particularly noticeable in the market for residential mortgage-backed securities (RMBS). Spreads at issuance for AA-rated RMBS tranches have, on average, declined by around 10 basis points from their 2005 levels and are around 35 basis points lower than two years ago. Spreads on AAA-rated tranches are around 10 basis points lower than in 2004 (Graph 40).

Intermediaries' interest rates

Following the 25 basis point increase in the target cash rate in early May, most lenders increased the indicator rates on their variable-rate housing loans by a similar amount (Table 11). In most cases, these increases were passed on to existing borrowers within a week of the policy announcement, similar to the experience of recent monetary policy changes. At the time of writing, intermediaries were yet to raise lending rates in response to the August monetary policy tightening.

While lenders in recent years have pegged their housing loan indicator rates to the cash rate, a declining proportion of loans has been extended at the indicator rate. Around 95 per cent of home loan borrowers now receive a discount on the indicator rate. The discounts are also becoming larger; the major banks' average advertised discount for a $250,000 variable-rate housing loan taken as part of a package is 60 basis points, almost 20 basis points more than the actual discount new borrowers received two years ago. Actual discounts currently received are likely to be higher, as some borrowers are able to negotiate larger-than-advertised discounts.

This discounting of home loans is part of a continuing trend towards increased competition in the home loan market that has been going on for over a decade. In 1996, the average home loan borrower was paying 2.5 percentage points more than the cash rate; now the margin is 1.2 percentage points. As a result, while the cash rate is now 50 basis points above its average since 1993, even full pass-through of the August tightening would see actual rates paid on housing loans around 30 basis points lower than their average (Table 12).

Most institutions also increased the rates on their personal loans and standard credit cards by 25 basis points following the May monetary policy tightening. However, competition remains intense in the low-rate (no-frills) segment of the credit card market, with some lenders actually lowering their rates following the tightening and more products being launched in the past few months.

Rates on fixed-rate housing loans have also increased since the time of the last Statement, in response to increases in the cost of funding fixed-rate loans. The major banks' average 3-year fixed housing rate has increased by 35 basis points since early May, to 7.20 per cent. This is probably a little above the average rate recently paid on new variable-rate housing loans, given the discounts that are available on those loans. Demand for fixed-rate housing loans has strengthened in recent months. Around 15 per cent of new owner-occupier housing loans were taken out at fixed rates in the three months to May (the latest figures available) compared with a longer-run average of 11 per cent.

Regarding business loans, intermediaries also increased their indicator rates on variable-rate business loans by 25 basis points after the May tightening. However, the weighted-average rate actually paid on variable-rate business loans – incorporating risk margins charged by banks – has also tended to rise less than the cash rate in recent years, consistent with competitive pressures in the business loan market. Fixed rates on small business loans have also increased since the last Statement, by around 45 basis points, to their highest level since 2000.

With regard to deposit accounts, relatively few institutions have increased their rates since the May tightening. Where they have increased deposit rates, it has typically been on their online savings accounts, the most competitive segment of the deposit market over the past few years.

Equity prices

Australian share prices continued to rise strongly in the first few months of 2006, with the ASX 200 reaching a record high in mid May. Since then, share prices have been volatile, and generally declining. They are currently around 7 per cent below their May peaks (Graph 41). Despite these falls, the index is still 5 per cent higher than at the start of 2006, whereas overseas markets have risen by around 2 per cent.

Daily movements in the share market were unusually large in May and June: the average absolute daily percentage change in the ASX 200 was 1.1 per cent in June, the largest since September 2001 (Graph 42). There was some moderation in volatility in July, though it remained above its historical average. The increase in volatility in recent months followed an unusually stable period in financial markets since early 2003.

For much of 2006 to date, volatility and weakness in prices largely reflected international developments, including some nervousness about the risk of rising global inflation and a number of geo-political events; domestic news was generally favourable. Consistent with this, analysts' earnings forecasts for domestically-listed companies have continued to be revised higher, including in the period since the previous Statement. Analysts are currently expecting growth in earnings per share (EPS) in 2005/06 of around 17 per cent, with a similar rate of growth expected for 2006/07. For both years, expected EPS growth for resources companies is around 40 to 45 per cent, with that for other companies in the ASX 200 around 8 per cent (Graph 43).

Measures of share market valuation have changed little in recent months: the price-to-earnings (P/E) ratio for the ASX 200 index is about 17, above its post-1975 average but below the average for the second half of the 1990s. The dividend yield is 3.8 per cent, slightly below its long-term average (Graph 44).

Prices of commercial property in Australia have also risen strongly over the past year (Graph 45).

Financing activity

Intermediated financing

After picking up noticeably in the first quarter of 2006, credit growth continued at a fast pace in the June quarter. As a result, total credit grew at an annual rate of almost 16 per cent over the six months to June (Graph 46 and Table 13). Growth was again strongest in the business component, but household credit growth was also solid at an annual rate of around 14¾ per cent, mainly driven by ongoing strength in borrowing for housing, particularly at fixed interest rates. (For further discussion, see the chapter on ‘Domestic Economic Conditions’.)

Over half the growth in personal credit over the six months to June was due to very strong growth in margin lending for the purchase of shares and managed funds. Margin debt rose by 15 per cent in the June quarter, and by nearly 40 per cent over the year, driven mainly by an increase in the average loan size (Graph 47). Demand for margin loans that incorporate capital protection was particularly strong in the June quarter, likely associated with the pick-up in share market volatility.

The average gearing ratio of borrowers with margin loans increased by 4 percentage points, to 42 per cent during the quarter, and the proportion of credit limits being used rose by a similar amount, to 49 per cent. These ratios remain low by historical standards. The sharp rise in share market volatility resulted in the frequency of margin calls almost doubling from the previous quarter, but it too remained low by historical standards.

Business credit continues to grow very rapidly and has recently run at around the fastest rates seen since the late 1980s. This has been driven by growth in borrowing by corporations, with more moderate increases in borrowing by unincorporated businesses, which are mainly small businesses and farms.

A broader, though less timely, measure of business credit includes direct lending by foreign financial intermediaries to Australian businesses – so-called cross-border lending. This measure has been growing at a faster pace than domestic business credit due to a sharp pick-up in cross-border lending since mid 2004. Year-ended growth in this broader measure of business credit has recently been around 3 percentage points faster than growth in domestic business credit.

Contributing to growth in business credit in the past few years and, in part, the strength of cross-border lending, has been increased activity in the syndicated lending market. A record $84 billion of syndicated loans were approved in 2005/06, 17 per cent higher than in the previous year (Graph 48). Almost all the growth in syndicated lending was due to an increase in the average loan size, reflecting an increase in the number of ‘jumbo’ deals, defined as loans in excess of A$1 billion each. Though refinancing remained the primary use for syndicated loans in 2005/06, accounting for almost 40 per cent by value, the pick-up in lending activity from the previous year was mostly due to mergers and acquisitions. Acquisition-related deals accounted for 30 per cent of syndicated loans in 2005/06, up from 22 per cent in the previous year.

Non-intermediated financing

Bond raisings by Australian non-government entities was again very strong in the June quarter, with $42 billion of new bonds issued (Table 14). Roughly equal amounts were issued in the domestic and offshore markets. Within the domestic market, a record $15 billion of asset-backed securities (ABS) was issued in the quarter. As discussed earlier, investor demand for these securities remains very strong. With issuance strongly outpacing maturities over the first half of the year, outstandings of non-government bonds in the domestic market rose by 20 per cent – the most rapid pace of six month-ended growth in almost seven years.

Equity raisings also picked up in the June quarter, for both financial and non-financial companies. As a result, total capital raisings (i.e. debt plus equity) were around $50 billion in the June quarter, compared with a quarterly average of around $30 billion in 2005.