4. Domestic Financial Markets

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1 . Domestic Financia Markets Money Markets and Bond Yieds The Reserve Bank Board owered its target for the cash rate from.75 per cent to.5 per cent in November, the first change in the target since November 1 (Graph.1). In recent months, there has been a significant reassessment of the outook for domestic monetary poicy by market participants, mainy refecting uncertainty about how the sovereign debt and banking probems in Europe might be resoved and the effects on goba economic activity. Market pricing at one point embodied an expectation of aggressive reductions in the cash rate incuding possibe moves between Board meetings in the event of a sharpy weaker word economy. Refecting this, rates on overnight indexed swaps (OIS) fe significanty in August, athough the voatiity of these rates suggested that sizeabe adjustments in derivative positions, at times, may have compromised the iquidity of the market. In subsequent months, the extent of expected easing has essened, though OIS rates sti impy that the cash rate wi reach a ow of 3½ per cent by the midde of 1. Interest rates on bank bis have aso decined. As in previous periods of market turmoi, the spreads between bank bi and OIS rates widened (Graph.). From basis points at the time of the previous Statement, the spread between 3-month bis and OIS briefy rose to over 75 basis points in mid August but much of this refected the arge fa in OIS rates. As iquidity in the OIS market has improved, and voatiity has abated, the 3-month spread on bank bis has setted back at around 3 basis points. More generay, the domestic Graph.1 Cash Rate Expectations Impied from OIS.5 Ju Aug Sep Oct 11 Sources: RBA; Tuett Prebon (Austraia) Pty Ltd 1 Actua cash rate Jun-1 Dec-11 Mar-1 Nov Graph. Spread of 3-month Bank Bis to OIS 7 Sources: AFMA; Tuett Prebon (Austraia) Pty Ltd interbank market has functioned smoothy in recent months and, in contrast to Europe where the European Centra Bank has had to intermediate the interbank market to circumvent counterparty concerns, the Bank has not had to make any STATEMENT ON MONETARY POLICY NOVEMBER 11 5

2 adjustments to the way it operates in financia markets. Through its open market operations, the Reserve Bank has kept the eve of exchange settement (ES) baances steady at around $11/ biion for more than 1 months, athough temporariy higher demand for baances continues to be accommodated on key baancing dates, such as quarter-ends. Government bond yieds have been voatie, driven by deveopments offshore. Through to eary October, ong-term bond yieds decined as goba bond markets raied and expectations for an easing in domestic monetary poicy intensified (Graph.3). The yied on 1-year Commonweath Government securities (CGS) reached a ow of per cent in eary October, before rising with increased optimism for a satisfactory resoution of the probems in Europe. In mid October, the nomina CGS yied curve was extended by the issuance of a 15-year bond, the first time bonds of this maturity have been issued since the 19s. (The Austraian Office of Financia Management (AOFM) reguary issues infationindexed bonds with as much as years to maturity.) The AOFM issued $3. biion a reativey arge amount for a new ine with a ong maturity at a yied that was 3 basis points above the yied on 1-year CGS. In contrast to many government securities overseas, yieds on ong-term CGS continue to trade at a significant margin beow the equivaent swap rate, refecting their reative scarcity. Spreads between CGS and other governmentreated securities (such as those issued by the state borrowing authorities and the supranationa agencies) widened appreciaby during August (Graph.). However, given the arge decine in CGS yieds, borrowing costs sti decined in most cases, notwithstanding the widening in spreads. Whie primary issuance was curtaied for a short period, borrowers have subsequenty returned to the market. Spreads have stabiised and, for certain issuers, have begun to decine. The spreads on supranationa debt, particuary for European-based issuers, remain wide Graph.3 Austraian Government Bond Yieds 1-year year M J S D 1 Queensand* M J S 11 Graph. Spreads to 5-year CGS D European Investment Bank * State-guaranteed debt; from March 9 to Apri 1 a debt of this maturity was guaranteed by the Austraian Government Sources: RBA; Yiedbroker Financia Intermediaries Victoria Continued strong growth in deposits and negative net bond issuance have contributed to a further shift in the composition of banks funding towards deposits (Graph.5). This trend has been evident since. Deposits currenty represent just over 51 per cent of banks funding, whie ong- and short-term whoesae funding each make up about one-fifth. The average rate on major banks new term deposit specias fe by around basis points over the past quarter, refecting the decine in market benchmark rates (Graph.). Banks have been bidding ess aggressivey for some forms of whoesae deposits, RESERVE BANK OF AUSTRALIA

3 particuary deposits from other financia institutions. Nonetheess, the spread paid on term deposits continues to be we above spreads on whoesae funding at both shorter and onger maturities. The average interest rate on the major banks at-ca deposits (incuding onine savings, bonus saver and cash management accounts) was broady unchanged over the three months to the end of October. Around $. biion worth of Austraian bank bonds have been issued since the August Statement compared with amost $5 biion in the previous three months. The buk of this issuance was from the major banks and more than three-fifths was in offshore markets (Graph.7). The reduction in suppy party refects voatie conditions in debt markets, but aso a reduced need for whoesae funding due to the strength of deposit growth reative to credit growth (see beow). Bank bond yieds have decined since the previous Statement and are currenty around 9 basis points beow their average for the first haf of 11 (Graph.). Notwithstanding this fa, domestic secondary market spreads of bank bonds over CGS have widened by around 5 basis points since the previous Statement, primariy refecting the deterioration of conditions in goba debt markets. Credit defaut swap (CDS) premia for Austraian banks have aso risen over recent months, and to a greater extent than the rise in unsecured bank bond spreads (Graph.9). This refects a broader trend across simiary rated banks esewhere in the word and coud be the resut of market participants buying protection against the occurrence of unikey but significant events, ike the advent of a goba recession. Athough CDS contracts are more standardised than bonds and trading activity is concentrated in a sma number of maturities (most notaby 5 years), trading voume is very ow and it is difficut to arbitrage the two markets, particuary when the CDS premium is above the bond spread. Graph.5 Funding Composition of Banks in Austraia* Domestic deposits Long-term debt Per cent of funding Short-term debt** Securitisation Equity * Adjusted for movements in foreign exchange rates ** Incudes deposits and intragroup funding from non-residents Sources: APRA; RBA; Standard & Poor's Cash rate At-ca deposits** (existing customers) Graph. Deposit Rates $1 deposits 3-month bank bi rate At-ca deposits** (new customers) Term deposit specias * * Average of 1 1, -, 3- and -month terms at the major banks ** Average of onine, bonus saver and cash management accounts at the major banks Offshore* Onshore* Maturities 3-3 Graph.7 Banks Bond Issuance A$ equivaent Net issuance * Latest quarter issuance to date STATEMENT ON MONETARY POLICY NOVEMBER 11 7

4 Graph. Major Banks Bond Pricing 3-year A$ debt Yieds Spread to Senior bank bond (rated AA) Swap CGS Graph.1 Bond Issuance and the Cross-currency Basis Swap Spread Austraian entities foreign currency issuance Issuance* Net issuance CGS Swap Sources: Boomberg; RBA; UBS AG, Austraia Branch Non-residents A$ issuance 5-year cross-currency basis swap spread Graph.9 Major Banks Bond Spreads and CDS Premia 5-year Euro US$ CDS premia * Latest quarter issuance to date Sources: Boomberg; RBA 1 5 Bond spreads to swap* * Domestic secondary market spreads converted into US$ spreads Sources: Boomberg; RBA Lower offshore issuance by the Austraian banks paced downward pressure on the US doar cross-currency basis swap spread for much of the past three months (Graph.1). This reduced the hedging costs of issuing offshore for Austraian banks but made the Austraian doar market ess advantageous for Kangaroo issuers swapping the funds raised out of Austraian doars. Since the previous Statement, Kangaroo issuance has totaed $1.7 biion, sowing from the arger suppy in the first haf of the year. In recent months, heightened concerns over European sovereign debt have aso weighed on investor sentiment in the Kangaroo bond market, where European issuers are quite 1 5 active. As a resut, Kangaroo bond spreads in the domestic secondary market have remained eevated since mid 11, further reducing the attractiveness of issuing in the domestic market. Five prime residentia mortgage-backed securities (RMBS) transactions totaing just over $5 biion have been issued over the past three months (Graph.11). Private investor demand continued to underpin these RMBS transactions, most of which incuded arge 3-year tranches. The AOFM invested $391 miion in two RMBS deas from non-major banks. Issuance spreads were around 5 basis points higher than those prevaiing in the June quarter. There were a number of other asset-backed deas in the quarter, incuding two commercia mortgagebacked securities (CMBS) and three asset-backed securities (ABS). CMBS worth $53 miion in aggregate were issued, however issuance in this sector remains subdued as investors remain cautious towards commercia property. A tota of $1.9 biion RESERVE BANK OF AUSTRALIA

5 1 Graph.11 Austraian RMBS Issuance* A$ equivaent Purchases by the AOFM Offshore Onshore 1 The major banks have reported profit resuts for their 11 financia years. Each bank reported a sight increase in its domestic net interest margin in the second haf of the reporting period. In aggregate, the net interest margin of the major banks has fuctuated in a narrow range since, of between 1/ and ½ percentage points (Graph.1). Graph.1 Major Banks Net Interest Margin* Domestic, haf-yeary * Latest quarter issuance to date in ABS has been issued since the previous Statement. The underying coatera backing the securities was mosty composed of auto oans and eases, as we as equipment eases. Legisation aowing Austraian authorised deposittaking institutions (ADIs) to issue covered bonds was passed in Pariament. Eigibe cover poo assets incude commercia and residentia property oans in Austraia, as we as iquid assets such as at-ca deposits convertibe to cash within two business days and Commonweath or state government bonds and notes. The tota amount of covered bonds that can be issued by an ADI is capped at per cent of the vaue of its Austraian assets to ensure that ADIs unsecured creditors, such as depositors, are not excessivey subordinated by covered bondhoders. A minimum over-coateraisation of 3 per cent is aso prescribed, and is incuded in the per cent cap. Broad prudentia powers have been given to APRA and rues have been prescribed for independent cover poo monitors and the need for ADIs to maintain cover poo registers. Indications are that some of the major banks may tap this market before the end of the year * From data are on an IFRS basis; prior years are on AGAAP basis; Excudes St George Bank and Bankwest prior to the first haf of 9 Sources: Banks financia reports; RBA Househod Financing Most enders eft their indicator rates on new standard variabe-rate housing oans unchanged over the three months to the end of October, athough one major bank introduced a temporary offer to undercut the rates of the other major banks (Tabe.1). In contrast, rates on new fixed-rate mortgages continued to fa. Competition remained strong in other aspects of housing ending, with one major bank announcing a cash-back offer for new mortgages. Overa, the average rate on outstanding housing oans (fixed and variabe) fe by about 9 basis points between the beginning of the year and the end of October, to be a itte above its post-199 average (Graph.13). Most banks have announced reductions in their indicator rates on variabe-rate housing oans foowing the decrease in the cash rate at the November Board meeting STATEMENT ON MONETARY POLICY NOVEMBER 11 9

6 Tabe.1: Intermediaries Variabe Lending Rates Per cent Leve at end October 11 August Statement Change since: End October 1 Housing oans (a) Persona oans Sma business Residentiay secured, advertised Term oans.99.. Overdraft 9... Average rate (b).1..9 Large business Average rate (b) (variabe-rate and bi funding) (a) Average of the major banks discounted package rates on $5 fu-doc oans (b) Rates on outstanding, as opposed to new, business ending Sources: ABS; APRA; RBA Graph.13 Average Interest Rates on Outstanding Lending Housing Graph.1 Vaue of Housing Loan Approvas Non-FHB owner-occupiers Net of refinancing Average 9 Tota Cash rate Investors First-home buyers Sources: ABS; APRA; Perpetua; RBA 3 7 Sources: ABS; RBA Competition in the mortgage market contributed to an increase in refinancing activity, with the vaue of housing oan approvas for refinancing purposes rising by 11 per cent over the three months to August, compared to a decade average of about 3 per cent. The vaue of housing oan approvas is currenty around ½ per cent beow its eve at the end of 1 (Graph.1). Housing credit grew at an annuaised rate of 5.9 per cent over the September quarter. Investor housing credit is sti growing ess quicky than owner-occupier credit, as has been the case since eary 11. In year-ended terms, tota housing credit is growing at its sowest rate in a coupe of decades (Graph.15). Persona credit continued to fa in the September quarter. This is argey the resut of fas in margin ending as recent voatiity in goba equity markets has ed to ess demand for margin oans. Credit card ending has aso faen sighty since eary in RESERVE BANK OF AUSTRALIA

7 Graph.15 Credit Growth Year-ended 3 3 Graph.1 Austraian Corporates Bond Issuance Offshore* Onshore* Maturities Housing 1 1 Tota* * Incudes housing, persona and business credit Business * Latest quarter issuance to date Business Financing Corporate bond issuance has picked up since August, when issuance was particuary affected by uncertainty arising from the European sovereign debt crisis (Graph.1). Around $5.7 biion has been issued since the previous Statement; bond maturities over recent months have been modest, reducing the refinancing task of Austraian corporates. A few investment-grade Austraian corporates, such as Rio Tinto, paced bonds in the US doar market for terms ranging from 5 to 9 years, which is difficut to achieve in the domestic corporate bond market. Origin Energy issued a 1-year bond, raising US$5 miion that wi be used to hep fund the company s Austraia Pacific coa seam gas to LNG project. Fortescue, which is beow investment grade, raised US$1.5 biion in an -year private pacement. Corporate bond spreads have widened by around 5 basis points since the previous Statement refecting increased risk aversion (Graph.17). Intermediated business credit grew at an annuaised rate of around per cent over the September quarter. The increase in business credit was driven by a rise in the vaue of foreign currency denominated ending, some of which was a consequence of the depreciation of the Austraian doar. Approvas for Graph.17 Austraian Corporates Bond Pricing 3-year A$ debt BBB corporates Yieds Spread to CGS CGS 11 Sources: RBA; UBS AG, Austraia Branch syndicated oans were soid over the September quarter, at amost $ biion. The number of syndicated oan approvas has been rising sowy since the end of, athough the vaue of approvas has remained steady. The majority of syndicated ending has been for capita and genera corporate expenditure. Net corporate externa funding increased in the September quarter with sma increases in a three components (Graph.1). The cost of intermediated business borrowing has faen over the past three months, mainy refecting a decine in market benchmark rates. Indicator rates on STATEMENT ON MONETARY POLICY NOVEMBER 11 51

8 Graph.19 Average Interest Rates on Outstanding Business Lending Graph. Listed Corporates Gearing Ratio* A isted corporates By sector Average Graph.1 Business Externa Funding Net change as a share of GDP Equity Business credit Non-intermediated debt Sources: ABS; ASX; Austracear Limited; RBA Tota Sma business 1 Average Large business Sources: APRA; RBA Infrastructure Other Rea estate Resources * Excudes foreign-domicied companies; incudes rea estate companies from 1997; book vaue debt over equity Sources: ABS; Boomberg; Morningstar; RBA; Statex; Thomson Reuters new fixed-rate business oans have faen by around basis points since Juy, whie indicator rates on new variabe-rate oans were argey unchanged at the end of October. The average rate on banks outstanding ending to arge business fe by 1 basis points over the three months to the end of October, to be ony sighty above its post-199 average (Graph.19). The average rate on outstanding sma business oans was itte changed at. per cent, about 3 basis points above its post-199 average. Listed corporates baance sheets continued to expand marginay in the June haf of 11 and gearing ratios decined further, to reach their owest eve since the eary 19s. Book vaue gearing the ratio of debt to the book vaue of sharehoders equity decined to per cent, we beow the cycica peak of over per cent in December (Graph.). The decine in everage refected a sma rise in equity due to higher retained profits but was mainy driven by debt restructuring by some prominent rea estate and infrastructure companies. The restructuring of Centro Properties Group contributed to a 15 percentage point reduction in the gearing ratio of rea estate companies, which now stands at around the eves of the mid s. Resource company gearing rose marginay as a resut of acquisitions by Rio Tinto and Origin Energy that were party funded by debt. BHP and Rio Tinto s buyback operations aso contributed, as did BHP s purchase in cash of Chesapeake Energy for US$.7 biion. Gearing in other sectors was marginay higher. Aggregate Credit Tota outstanding credit grew at an annuaised rate of around per cent over the September quarter, with moderate growth in househod credit and a sma increase in business credit (Tabe.). Growth in broad money was consideraby stronger than growth in credit, refecting a preference by househods and businesses to hod their assets in deposits, particuary given the uncertainty surrounding equity markets. 5 RESERVE BANK OF AUSTRALIA

9 Tabe.: Financia Aggregates Percentage change Average monthy growth June quarter 11 September quarter 11 Year to September 11 Tota credit Owner-occupier housing.5.5. Investor housing.3.. Persona Business... Broad money Equity Markets The intensification of European sovereign debt concerns and uncertainty over the pace of the goba recovery weighed heaviy on the oca share market in August and September (Graph.1). Voatiity increased significanty to eves ast seen during the financia crisis. Resource stocks, which have a weight of around one-third in the ASX, fe by 1 per cent over August and September as commodity prices decined (Graph.). However, with goba growth concerns dissipating somewhat, resource stocks have subsequenty rebounded and are now 1 per cent ower than they were three months ago. The ASX is currenty around 1 per cent beow its peak in Apri this year. Share prices of financias have risen by per cent since the previous Statement. Share prices of commercia banks have ed the financia sector, whie diversified financias have faen as anaysts have downgraded their earnings forecasts for the arger institutions. Some insurance groups aso experienced arge fas on the back of concerns over the impact of ower domestic and goba interest rates on future investment income. Profits announced by ASX isted companies during the recent reporting season rose substantiay over the year, broady matching expectations. Underying profits which excude significant items and asset revauations/saes rose by per cent in the June haf of 11 from the corresponding Index Index ASX Graph.1 Share Price Indices End December = 1 Sources: Boomberg; Thomson Reuters S&P 5 MSCI Word excuding US M J S D M J S D M J S D Graph. Austraian Share Price Indices 7 Sources: Boomberg; RBA End December = 1 Resources A other sectors Financias Index Index STATEMENT ON MONETARY POLICY NOVEMBER 11 53

10 15 1 period in 1. Profits were stronger across most sectors, athough the resource sector made the argest contribution to the increase in aggregate profits. Bostered by higher commodity prices, resource profits rose 5 per cent from the same period in 1, but decined by 1 per cent from their record eve in the December haf of 1, refecting the impact of weather-reated disruptions to production, cost increases and currency vauation effects (Graph.3). Graph.3 Underying Profits of ASX Companies* 5 Resources By sector, a companies Financias A other sectors * From December figures reported under IFRS Sources: Morningstar; RBA; company reports 11 Financias profits rose by 1 per cent from the June haf of 1, with rea estate companies profits rising by 3 per cent compared with their depressed eves in the June haf of 1. Profits at insurance companies increased by per cent from the June haf of 1 with a few arge companies driving most of the improvement on the back of acquisitions and a reassessment of caims such as those stemming from natura disasters. The profits of other companies rose by 15 per cent, but have been broady steady for the past few years With share prices having decined and profits strong, price earnings ratios for Austraian companies are we their beow ong-run averages. Simiary, dividend yieds have risen. Aggregate dividends in the first haf of 11 were marginay higher than those over recent reporting periods. New announcements of buybacks, which were very arge in the second haf of 1, decined sharpy in the June haf of 11, causing a substantia decine in tota sharehoder distributions the sum of buybacks and aggregate dividends. This was driven by the arge mining companies. Rio Tinto announced that it woud increase its buyback program by US$ biion, whie BHP did not announce any new buyback commitments as it proceeds with competing some arge acquisitions. There has been around $1 biion of merger and acquisition activity announced over the past three months, comprised of a number of sma deas. The board of Fosters has recommended that its sharehoders accept an improved offer of $1.7 biion from SABMier when they vote on the proposed takeover in December. Peabody Energy has acquired a majority stake in Macarthur Coa after sharehoders accepted a $.9 biion bid for the company. R 5 RESERVE BANK OF AUSTRALIA

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