But in its 53 pages of “dry banker speak” there are some important facts which shows just how much of the global financial system is now interconnected.
They start by making the point that over the past three decades, and despite a slowdown coinciding with the global financial crisis (GFC) of 2007–09, the degree of international financial integration has increased relentlessly.
In fact the rapid pace of financial globalisation over the past decades has also been reflected in an over sixfold increase in the external assets and liabilities of nations as a share of GDP – despite a marked slowdown in the growth of cross-border positions in the immediate aftermath of the GFC.
This chart shows the evolution of advanced economies’ financial exposures to a group of large middle-income countries, split into portfolio exposures and bank exposures. It shows that both types of exposures have increased substantially since the late 1990s.
Here is another chart which again the linkages, looking at cross-border liabilities by counterparty. The chart shows the classification of cross-border debt liabilities by type of counterparty. It shows that cross-border liabilities where both creditor and debtor are banks are the largest of the four possible categories, and increased rapidly in the run-up to the GFC. It also shows a rapid increase in credit flows relative to foreign direct investments (FDI) and portfolio equity flows.
They explain that cross-border bank-to-bank funding (liabilities) can be decomposed into two distinctive forms: (a) arm’s length (interbank) funding that takes place between unrelated banks; and (b) related (intragroup) funding that takes place in an internal capital market between global parent banks and their foreign affiliates. They note that cross-border bank-to-bank liabilities have also played a major role in the expansion of domestic lending, at their peak in 2007 these flows accounted for more than 25% of total private credit of the recipient economy.
This also opens the door to potential arbitrage, for example “rebooking” of loans, whereby loans are originated by subsidiaries but then booked on the balance sheet of the parent institution. Indeed, the presence of foreign branches of financial institutions that are not subject to host country regulation may undermine domestic macroprudential policies.
This degree of global linkage raises significant issues, despite the argument trotted about by economists that there are benefits from the improved efficiency of resource allocation.
First, the increased global interconnectedness has led to new risks, associated with the amplification of shocks during turbulent times and the transmission of excess financial volatility through international capital flows. They suggest there is robust evidence that private capital flows have been a major conduit of global financial shocks across countries and have helped fuel domestic credit booms that have often ended in financial crises, especially in developing economies.
Second, international capital flows have created macroeconomic policy challenges for advanced economies as well. For example, the rest of the world’s appetite for US safe assets was an important factor behind the credit and asset price booms in the United States that fuelled the subsequent financial crisis and created turmoil around the world. It is also well documented that since the GFC, the various forms of accommodative monetary policy pursued in the United States and the euro area have exerted significant spillover effects on other countries by influencing interest rates and credit conditions around the world – irrespective, at first sight, of the nature of the exchange rate regime.
Finally, there is evidence to suggest that in recent years financial market volatility in some large middle-income countries has been transmitted back, and to a greater extent, to asset prices in advanced economies and other countries. For instance, the suspension of trading after the Chinese stock market drop on 6 January 2016 affected major asset markets all over the world. Thus, international spillovers have become a two-way street – with the potential to create financial instability in both directions.
This means that macroeconomic settings in the USA – and especially the progressive rise in their benchmark rate, and reversal of QE, will have flow-on effects which will resonate around the global financial system. In a way, no country is an island.
The paper does also make the point that there may be some benefits – for example, if the global economy is experiencing a recession for instance, the coordinated adoption of an expansionary fiscal policy stance by a group of large countries may, through trade and financial spillovers, benefit all countries. The magnitude of this gain may actually increase with the degree to which countries are interconnected, the degree of business cycle synchronisation, and the very magnitude of spillovers.
But, if maintaining financial stability is a key policy objective, the propagation of financial risks through volatile short-term capital flows also becomes a source of concern.
After detailed analysis the paper reaches the following conclusions.
First, with the advance in global financial integration over the last three decades, the transmission of shocks has become a two-way street – from advanced economies to the rest of the world, but also and increasingly from a group of large middle-income countries, which we refer to as SMICs, to the rest of the world, including major advanced economies. These increased spillbacks have strengthened incentives for advanced economies to internalise the impact of their policies on these countries, and the rest of the world in general. Although stronger spillovers and spillbacks are not in and of themselves an argument for greater policy coordination between these economies, the fact that they may exacerbate financial risks – especially when countries are in different phases of their economic and financial cycles – and threaten global financial stability is.
Second, the disconnect between the global scope of financial markets and the national scope of financial regulation has become increasingly apparent, through leakages and cross-border arbitrage – especially through global banks. In fact, what we have learned from the financial trilemma is that it has become increasingly difficult to maintain domestic financial stability without enhancing cross-border macroprudential policy coordination, at least in its structural dimension. Avoiding the leakages stemming from international regulatory arbitrage and open capital markets requires cooperation, but addressing cyclical risks requires coordination.
Third, divergent policies and policy preferences contribute additional dimensions to global financial risks. In the absence of a centralised macroprudential authority, coordination needs to rely on an international macroprudential regime that promotes global welfare. Yet, divergence in national interests can make coordination unfeasible. Fourth, significant gaps remain in the evidence on regulatory spillovers and arbitrage, and the role of the macroprudential regime in the cross-border transmission of shocks. In addition, research on the potential gains associated with multilateral coordination of macroprudential policies remains limited. This may be due in part to the natural or instinctive focus of national authorities on their own country’s objectives, or to greater priority on policy coordination within countries – an important ongoing debate in the context of monetary and macroprudential policies. This “inward” focus may itself be due to the lack of perception of the benefits of multilateralism with respect to achieving national objectives – which therefore makes further research on these benefits all the more important.
This assessment suggests that, in a financially integrated world, international coordination of macroprudential policies may not only be valuable, but also essential, for macroprudential instruments to be effective at the national level. A first step towards coordination has been taken with Basel III’s principle of jurisdictional reciprocity for countercyclical capital buffers, but this principle needs to be extended to a larger array of macroprudential instruments. Further empirical and analytical work (including by the BIS, FSB and IMF) on the benefits of international
macroprudential policy coordination could play a significant role in promoting more awareness of the potential gains associated with global financial stability. This work agenda should involve a research component focused on measuring the gains from coordination and improving data on cross-border financial flows intermediated by various entities (banks, investment funds and large institutional investors), as well as improving capacity for systemic risk monitoring.
My own take is that we have been sleepwalking into a scenario where large capital flows and international financial players operating cross borders, negating the effectiveness of local macroeconomic measures, to their own ends. This new world is one where large global players end up with more power to influence outcomes than governments. No wonder that they often march in step, in terms of seeking outcomes which benefit the financial system machine.
Somewhere along the road, we have lost the plot, but unless radical changes are made, the Genie cannot be put back into the bottle. This should concern us all.
Supervisors who monitor the health of the financial system know that a rapid buildup of debt during an economic boom can spell trouble down the road. That is why they keep a close eye on the overall volume of credit in the economy. When companies go on a borrowing spree, supervisors and regulators may decide to put the brakes on credit growth.
Trouble is, measuring credit volume overlooks an important question: how much of that additional money flows to riskier companies – which are more likely to default in times of trouble—compared with more creditworthy firms? The IMF’s latest Global Financial Stability Report seeks to fill that gap by constructing measures of the riskiness of credit allocation, which should help policy makers spot clouds on the economic horizon.
Our researchers crunched 25 years of data for nonfinancial companies in 55 emerging and advanced economies. They found that when credit grows rapidly, the firms where debt expands faster become increasingly risky in relation to those with the slowest debt expansions. Such an increase in the riskiness of credit allocation, in turn, points to greater odds of a severe economic downturn or a banking crisis as many as three years into the future.
This buildup of lending to relatively less creditworthy companies adds an extra dose of risk – on top of the dangers that may come with the rapid growth of credit overall. Of course, lending to risky firms may be perfectly rational and profitable. But it can also spell trouble if it reflects poorer screening of borrowers or excessive risk-taking.
Fortunately, regulators can take steps to protect the financial system, if necessary. They can require banks to hold more capital or impose limits on bank loan growth, restraining their risk-bearing capacity and increasing their buffers. Ensuring the independence of bank supervisors, enforcing lending standards, and strengthening corporate governance by protecting minority shareholders can also help keep risks in check.
Why does more credit flow to risker firms in good times? It’s possible that investors are unduly optimistic about future economic prospects, leading them to extend credit to more vulnerable firms. If interest rates are unusually low, banks and investors may be tempted to lend money – in the form of loans or bonds – to riskier companies that pay relatively higher rates of interest. We have seen this “search for yield” in advanced economies in recent years because of the prolonged period of ultra-low interest rates. The riskiness of credit allocation may thus be a good barometer of risk appetite.
Our study found a clear global pattern in the evolution of this new measure of financial vulnerability. Starting at elevated levels in the late 1990s, the riskiness of credit allocation fell from 2000 to 2004, in the aftermath of financial crises in Asia and Russia and the dot-com equity bubble. From a historic low in 2004, riskiness rose to a peak in 2008, when the global financial crisis erupted. It then declined sharply before rising again to a level near its historical average at the end of 2016, the last available data point. Riskiness may have continued to rise in 2017 as market volatility and interest rates remained very low in the global economy.
The Global Financial Stability Report holds a clear lesson for policy makers and regulators: both the total volume of credit and the riskiness of its allocation are important. A period of rapid growth is more likely to be followed by a severe economic downturn if more of that credit is flowing to riskier firms. Policy makers should pay close attention to both measures – and take the appropriate steps when warning signals flash.
The latest BBSW data shows the trajectory in recent weeks. This will add more pressure to bank funding costs.
The question to consider is whether these moves are reflective of changes in global rates – LIBOR for example is higher (see below) – or whether this reflects the perceived risks in the local bank market in the light of the first rounds from the Royal Commission, which has generally underscored potential risks in their lending books. Or both.
The international rates are probably more the cause of the move of 25 basis points or more, which is significant because it suggests more upward pressure ahead, irrespective of what the RBA may choose to do.
We think mortgage rates will likely (and quietly) go higher in the months ahead.
Welcome to the Property Imperative Weekly to 07 April 2018.
Watch the video, or read the transcript.
In this week’s digest of finance and property news, we start with Paul Keating’s (he of the recession we had to have fame), comment that the housing boom is really over at the recent AFR conference.
He said that the banks were facing tighter controls as a result of the Basel rules on capital adequacy, while financial regulators had had a “gutful” of them. This was likely to lead to changes that would restrict the banks’ ability to lend. He cited APRA’s recent interventions in interest only loans as one example, as they restrict their growth. Keating also said the royal commission into misconduct in the banking and financial services sector would also “make life harder” for the banks and pointed out that banks did not really want to lend to business these days and would “rather just do housing loans”. Finally, he spoke of the “misincentives” within the big banks to grow their business by writing new mortgages, including having a high proportion of interest-only lending.
Anna Bligh speaking at the AFR event, marked last Tuesday her first year as CEO of the Australian Banking Association (ABA) – but said she feels “like 500 years” have already passed. Commenting on the Royal Commission she warned that credit could become tighter ahead. The was she said an opportunity for a major reset, not only in how we do banking but how we think about it, its place in our lives, its role in our economy and, most of all, it’s trustworthiness”.
At the same conference, Rod Simms the Chair of the ACCC speech “Synchronised swimming versus competition in banking” He discussed the results of their recent investigation into mortgage pricing, and also discussed the broader issues of competition versus financial stability in banking. He warned that the industry should be aware of, and respond to, the fact that the drive for consumers to get a better deal out of banking is shared by many beyond the ACCC. Every household in Australia is watching. You can watch our video blog on this for more details.
He specifically called out a lack of vigorous mortgage price competition between the five big Banks, hence “synchronised swimming”. Indeed, he says discounting is not synonymous with vigorous price competition. They saw evidence of communications “referring to the need to avoid disrupting mutually beneficial pricing outcomes”.
He also said residential mortgages and personal banking more generally make one of the strongest cases for data portability and data access by customers to overcome the inertia of changing lenders.
Finally, on competition. he says if we continue to insulate our major banks from the consequences of their poor decisions, we risk stifling the cultural change many say is needed within our major banks to put the needs of their customers first. Vigorous competition is a powerful mechanism for driving improved efficiency, and also for driving improved price and service offerings to customers. It can in fact lead to better stability outcomes.
This puts the ACCC at odds with APRA who recent again stated their preference for financial stability over competition – yet in fact these two elements are not necessarily polar opposites!
Then there was the report from the good people at UBS has published further analysis of the mortgage market, arguing that the Royal Commission outcomes are likely to drive a further material tightening in mortgage underwriting. As a result, they think households “borrowing power” could drop by ~35%, mainly thanks to changes to analysis of expenses, as the HEM benchmark, so much critised in the Inquiry, is revised. Their starting point assumes a family of four has living expenses equal to the HEM ‘Basic’ benchmark of $32,400 p.a. (ie less than the Old Age Pension). This is broadly consistent with the Major banks’ lending practices through 2017. As a result, the borrowing limits provided by the banks’ home loan calculators fell by ~35% (Loan-to-Income ratio fell from ~5-6x to ~3-4x). This leads to a reduction in housing credit and a further potential fall in home prices.
Our latest mortgage stress data, which was picked by Channel Nine and 2GB, thanks to Ross Greenwood, Across Australia, more than 956,000 households are estimated to be now in mortgage stress (last month 924,500). This equates to 30.0% of households. In addition, more than 21,000 of these are in severe stress, no change from last month. We estimate that more than 55,000 households risk 30-day default in the next 12 months. We expect bank portfolio losses to be around 2.8 basis points, though with losses in WA are higher at 4.9 basis points. Flat wages growth, rising living costs and higher real mortgage rates are all adding to the burden. This is not sustainable and we are expecting lending growth to continue to moderate in the months ahead as underwriting standards are tightened and home prices fall further”. The latest household debt to income ratio is now at a record 188.6. You can watch our separate video blog on this important topic.
ABS data this week showed The number of dwellings approved in Australia fell for the fifth straight month in February 2018 in trend terms with a 0.1 per cent decline. Approvals for private sector houses have remained stable at around 10,000 for a number of months. But unit approvals have fallen for five months. Overall, building activity continues to slow from its record high in 2016. And the sizeable fall in the number of apartments and high density dwellings being approved comes at a time when a near record volume are currently under construction. If you assume 18-24 months between approval and completion, then we still have 150,000 or more units, mainly in the eastern urban centres to come on stream. More downward pressure on home prices. This helps to explain the rise in 100% loans on offer via some developers plus additional incentives to try to shift already built, or under construction property.
CoreLogic reported last week’s Easter period slowdown saw 670 homes taken to auction across the combined capital cities, down significantly on the week prior when a record number of auctions were held (3,990). The lower volumes last week returned a higher final clearance rate, with 64.8 per cent of homes selling, increasing on the 62.7 per cent the previous week. Both clearance rate and auctions volumes fell across Melbourne last week, with only 152 held and 65.5 per cent clearing, down on the week prior when 2,071 auctions were held across the city returning a slightly higher 65.8 per cent success rate.
Sydney had the highest volume of auctions of all the capital city auction markets last week, with 394 held and a clearance rate of 67.9 per cent, increasing on the previous week’s 61.1 per cent across a higher 1,383 auctions.
Across the smaller capital cities, clearance rates improved week-on-week in Canberra, Perth and Tasmania; however, volumes were significantly lower across each market last week compared to the week prior.
Across the non-capital city auction markets, the Geelong region recorded the strongest clearance rate last week with 100 per cent of the 20 auction results reporting as successful.
The number of homes scheduled to go to auction this week will increase across the combined capital cities with 1,679 currently being tracked by CoreLogic, up from last week when only 670 auctions were held over the Easter period slowdown.
Melbourne is expected to see the most significant increase in volumes this, with 669 properties scheduled for auction, up from 152 auctions held last week. In Sydney, 725 homes are set to go to auction this week, increasing on the 394 held last week.
Outside of Sydney and Melbourne, each of the remaining capital cities will see a higher number of auctions this week compared to last week.
Overall auction activity is set to be lower than one year ago, when 3,517 were held over what was the pre-Easter week last year.
Finally, with local news all looking quite negative, let’s look across to the USA as the most powerful banker in the world, JPMorgan Chase CEO Jamie Dimon, just released his annual letter to shareholders. Given his bank’s massive size (it earned $24.4 billion on $103.6 billion in revenue last year) and reach (it’s a giant in consumer/commercial banking, investment banking and wealth management), Dimon has his figure on the financial pulse.
He says that’s while the US economy seems healthy today and he’s bullish for the “next year or so” he admits that the US is facing some serious economic headwinds.
For one, he’s concerned the unwinding of quantitative easing (QE) could have unintended consequences. Remember- QE is just a fancy name for the trillions of dollars that the Federal Reserve conjured out of thin air.
He said – Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal.
We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate – reacting to the markets, not guiding the markets.
And of course the DOW finished the week on a down trend, down 2.34%, and wiping out all the value gained this year, and volatility is way up. Here is a plot of the DOW.
This extreme volatility does suggest the bull market is nearing its end… if it hasn’t ended already. Dimon seems pretty sure we’re in for more volatility and higher interest rates. One scenario that would require higher rates from the Fed is higher inflation:
If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing – and wages start going up, as do commodity prices – then it is not an unreasonable possibility that inflation could go higher than people might expect.
As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment.
Now– here’s the important part. For the past ten years, the largest buyer of US government debt was the Federal Reserve. But now that QE has ended, the US government just lost its biggest lender.
Dimon thinks other major buyers, including foreign central banks, the Chinese, etc. could also reduce their purchases of US government debt. That, coupled with the US government’s ongoing trade deficits (which will be funded by issuing debt), could also lead to higher rates…
So we could be going into a situation where the Fed will have to raise rates faster and/ or sell more securities, which certainly could lead to more uncertainty and market volatility. Whether this would lead to a recession or not, we don’t know.
We’ll leave you with one final point from Jamie Dimon. He acknowledges markets have a mind of their own, regardless of what the fundamentals say. And he sees a real risk “that volatile and declining markets can lead to a market panic.”
Financial markets have a life of their own and are sometimes barely connected to the real economy (most people don’t pay much attention to the financial markets nor do the markets affect them very much). Volatile markets and/or declining markets generally have been a reaction to the economic environment. Most of the major downturns in the market since the Great Depression reflect negative future expectations due to a potential or real recession. In almost all of these cases, stock markets fell, credit losses increased and credit spreads rose, among other disruptions. The biggest negative effect of volatile markets is that it can create market panic, which could start to slow the growth of the real economy. Because the experience of 2009 is so recent, there is always a chance that people may overreact.
Dimon cautioned investors that interest rates could rise much sooner than they expect. If inflation suddenly comes roaring back. Indeed, it’s entirely possible the 10-year could break above 4% in the near future as inflation returns to 2% and the Fed shrinks its balance sheet.
Dimon also cast a wary eye toward exchange-traded funds, which have seen their popularity multiply since the financial crisis. There are now many ETF products that are considerably more liquid than their underlying assets. In fact far more money than before (about $9 trillion of assets, which represents about 30% of total mutual fund long-term assets) is managed passively in index funds or ETFs (both of which are very easy to get out of). Some of these funds provide far more liquidity to the customer than the underlying assets in the fund, and it is reasonable to worry about what would happen if these funds went into large liquidation.
And Finally America’s net debt currently stands at 77% of GDP (this is already historically high but not unprecedented). The chart below also shows the Congressional Budget Oﬃce’s estimate of the total U.S. debt to GDP, assuming a 2% real GDP growth rate. Hopefully, with the right policies they can grow faster than 2%. But more debt does seem on the cards.
And to add to that perspective, we spoke about the recent Brookings report which highlighted the rise in non conforming housing debt in the USA. debt as lending standards are once again being loosened, and risks to mortgage services are rising.
The authors quote former Ginnie Mae president Ted Tozer concerning the stress between Ginnie Mae and their nonbank counterparties.
… Today almost two thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights and all of these things have created a new and challenging environment for Ginnie Mae. . . . In other words, the risk is a lot higher and business models of our issuers are a lot more complex. Add in sharply higher annual volumes, and these risks are amplified many times over. . . . Also, we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks…
They say that goldfish have the shortest memory in the Animal Kingdom… something like 3-seconds. But not even a decade after these loans nearly brought down the entire global economy, SUBPRIME IS BACK. In fact it’s one of the fastest growing investments among banks in the United States. Over the last twelve months the subprime volume among US banks doubled, and it’s already on pace to double again this year.
The stock market is at record highs and people with FICO scores as low as 500 are once again happily obtaining mortgages. Not only that, but these mortgages are once again being securitized and are in demand by yield chasers.
All of the elements that are necessary for the 2008 subprime crisis to repeat itself are starting to fall back into place. Aside from the fact that we have inflated bubbles across basically all asset classes for the most part, not the least of which is evident in the stock market, the Financial Times reported today that not only are subprime mortgage backed securities becoming prominent again, but that the chase for yield was what fueling demand:
Issuance of securities backed by riskier US mortgages roughly doubled in the first quarter from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago. Home loans to people with scratches and dents in their credit histories dwindled to almost nothing in the aftermath of the crisis, as litigation-weary lenders retreated to patch up their balance sheets.
But over the past couple of years a group of specialist firms has begun to bring the loans back, navigating a dense web of new rules drawn up to protect borrowers and investors in the $9.3tn US home-loan market. Last year saw issuance of $4.1bn of securities backed by loans that would have been called “subprime” before the last financial crisis, according to figures from Inside Mortgage Finance, with the pace picking up in the latter half of the year. The momentum has continued into 2018, with deals worth $1.3bn in the first quarter — twice the $666m issued in the same period a year earlier.
Our central banks have done such a great job of getting us out of our last crisis that the recovery has prompted a mortgage originators and real estate investors to basically do the same exact thing that they were doing 2006 to 2007. After all, mortgage levels are already almost back to 2008 levels.
If that wasn’t disturbing enough, the hedge fund partner that FT quotes in the article says that the subprime market has “a lot of room to grow“ as if it were some type of new emerging market generating productivity, and not just a carbon copy repeat of exactly what happen nearly 10 years ago.
“The market is . . . starting from such a small base that it has a lot of room to grow,” said Jamshed Engineer, a partner at Axonic Capital, a New York hedge fund with more than $2bn in assets under management.
“[Investors] are definitely chasing yields. Whenever these deals come out, for the most part, they are oversubscribed.”
Relaxes a host of reporting requirements for small – medium banks, and to a smaller extent, large banks
Eliminates a reporting requirement introduced by Dodd-Frank designed to avoid discriminatory lending
Relaxes stress testing requirements intended to show how banks would survive another financial crisis
Raises the threshold for banks which are not subject to enhanced liquidity requirements, stress tests, and enhanced risk management, from $50 billion to $250 billion – exempting several institutions which could pose systemic risks down the road.
Allows megabanks such as Citi to count municipal bonds as “highly liquid assets” that could be used towards the “liquidity coverage ratio,” – assets which can be quickly liquidated during a crisis.
Calls for a report on the risks and benefits of algorithmic trading within 18 months
Despite the fact that the FT states that 500 FICO scores are getting approved for mortgages, S&P, one of the willfully ignorant and blind rating agencies that missed the subprime crisis thinks that everything is going to be fine:
“The risk is contained, in our view,” said Mr Saha.
For the way that our Federal Reserve has addressed the problems of 2007 or 2008, these are the end results that they deserve, but the American people ultimately do not.
Today we examine the recent Financial Market Earthquakes and ask, are these indicators of more trouble ahead?
Welcome to the Property Imperative Weekly to 24th March 2018. Watch the video or read the transcript.
In this week’s review of property and finance news we start with the recent market movements and consider the impact locally.
The Dow 30 has come back, slumping more than 1,100 points between Thursday and Friday, and ending the week in correction territory – meaning down more than 10% from its recent high.
The volatility index – the VIX which shows the perceived risks in the financial markets also rose, up 6.5% just yesterday to 24.8, not yet at the giddy heights it hit in February, but way higher than we have seen for a long time – so perceived risks are higher.
And the Aussie Dollar slipped against the US$ to below 77 cents from above 80, and it is likely to drift lower ahead, which may help our export trade, but will likely lead to higher costs for imports, which in turn will put pressure on inflation and the RBA to lift the cash rate. The local stock market was also down, significantly. Here is a plot of the S&P ASX 100 for the past year or so. We are back to levels last seen in October 2017. Expect more uncertainty ahead.
So, let’s look at the factors driving these market gyrations. First of course U.S. President Donald Trump’s signed an executive memorandum, imposing tariffs on up to $50 billion in Chinese imports and in response the Dow slumped more than 700 points on Thursday. There was a swift response from Beijing, who released a dossier of potential retaliation targets on 128 U.S. products. Targets include wine, fresh fruit, dried fruit and nuts, steel pipes, modified ethanol, and ginseng, all of which could see a 15% duty, while a 25% tariff could be imposed on U.S. pork and recycled aluminium goods. We also heard Australia’s exemptions from tariffs may only be temporary.
Some other factors also weighed on the market. Crude oil prices rose more than 5.5% this week as following an unexpected draw in U.S. crude supplies and rising geopolitical tensions in the middle east. Crude settled 2.5% higher on Friday after the Saudi Energy Minister said OPEC and non-OPEC members could extend production cuts into 2019 to reduce global oil inventories. Here is the plot of Brent Oil futures which tells the story.
Bitcoins promising rally faded again. Earlier Bitcoin rallied from a low of $7,240 to a high of $9175.20 thanks to easing fears that the G20 meeting Monday would encourage a crackdown on cryptocurrencies. Finance ministers and central bankers from the world’s 20 largest economies only called on regulators to “continue their monitoring of crypto-assets” and stopped short of any specific action to regulate cryptocurrencies. So Bitcoin rose 2% over the past seven days, Ripple XRP fell 8.93%and Ethereum fell 14.20%. Crypto currencies remain highly speculative. I am still working on my more detailed post, as the ground keeps shifting.
Gold prices enjoyed one of their best weeks in more than a month buoyed by a flight-to-safety as investors opted for a safe-haven thanks to the events we have discussed. However, the futures data shows many traders continued to slash their bullish bets on gold. So it may not go much higher. So there may be no relief here.
Then there was the Federal Reserve statement, which despite hiking rates by 0.25%, failed to add a fourth rate hike to its monetary policy projections and also scaled back its labour market expectations. Some argued that the Fed’s decision to raise its growth rate but keep its outlook on inflation relatively unchanged was dovish. Growth is expected to run at 3%, but core inflation is forecast for 2019 and 2020 at 2.10%. They did, however, signal a faster pace of monetary policy tightening, upping its outlook on rates for both 2019 and 2020. You can watch our separate video blog on this. The “dots” chart also shows more to come, up to 8 lifts over two years, which would take the Fed rate to above 3%. The supporting data shows the economy is running “hot” and inflation is expected to rise further. This will have global impact. The era of low interest rates in ending. The QE experiment is also over, but the debt legacy will last a generation.
All this will have a significant impact on rates in the financial markets, putting more pressure on borrowing companies in the US, and the costs of Government debt. US mortgage interest rates rose again, a precursor to higher rates down the track.
Moodys’ said this week, that the U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a levelling off of global business activity.
The flow on effect of rate rises is already hitting the local banks in Australia. To underscore that here is a plot of the A$ Bill/OIS Swap rate, a critical benchmark for bank funding. In fact, looking over the past month, the difference, or spread has grown by around 20 basis points, and is independent from any expectation of an RBA rate change. The BBSW is the reference point used to set interest rates on most business loans, and also flows through to personal lending rates and mortgages.
As a result, there is increasing margin pressure on the banks. In the round, you can assume a 10 basis point rise in the spread will translate to a one basis point loss of margin, unless banks reduce yields on deposit accounts, or lift mortgage rates. Individual banks ae placed differently, with ANZ most insulated, thanks to their recent capital initiatives, and Suncorp the most exposed.
In fact, Suncorp already announced that Variable Owner Occupier Principal and Interest rates will rise by 5 basis points. Variable Investor Principal and Interest rates will increase by 8 basis points, and Variable Interest Only rates increase go up by 12 basis points. In addition, their variable Small Business rates will increase by 15 basis points and their business Line of Credit rates will increase by 25 basis points. Expect more ahead from other lenders. The key takeaway is that funding costs in Australia are going up at a time when the RBA is stuck in neutral. It highlights how what happens with rates and in money markets overseas, and particularly in the US, can have repercussions here – repercussions that many are possibly unprepared for.
Locally, the latest Australian Bureau of Statistics showed that home prices to December 2017 fell in Sydney over the past quarter, along with Darwin. Other centres saw a rise, but the rotation is in hand. Overall, the price index for residential properties for the weighted average of the eight capital cities rose 1.0% in the December quarter 2017. The index rose 5.0% through the year to the December quarter 2017.
The capital city residential property price indexes rose in Melbourne (+2.6%), Perth (+1.1%), Brisbane (+0.9%), Hobart (+3.9%), Canberra (+1.7%) and Adelaide (+0.6%) and fell in Sydney (-0.1%) and Darwin (-1.5%). You can watch our separate video on this, where we also covered in more detail the January 2018 mortgage default data from Standard & Poor’s. It increased to 1.30% from 1.07% in December. No area was exempt from the increase with loans in arrears by more than 30 days increasing in January in every state and territory. Western Australia remains the home of the nation’s highest arrears, where loans in arrears more than 30 days rose to 2.44% in January from 2.08% in December, reaching a new record high. Conversely, New South Wales continues to have the lowest arrears among the more populous states at 0.98% in January. Moody’s is now expecting a 10% correction in some home prices this year.
According to latest figures released by the Australian Bureau of Statistics (ABS), the seasonally adjusted unemployment rate increased to 5.6 per cent and the labour force participation rate increased by less than 0.1 percentage points to 65.7 per cent. The number of persons employed increased by 18,000 in February 2018. So no hints of any wage rises soon, as it is generally held that 5% unemployment would lead to higher wages – though even then, I am less convinced.
The latest final auction clearance results from CoreLogic, published last Thursday showed the final auction clearance rate across the combined capital cities rose to 66 per cent across a total of 3,136 auctions last week; making it the second busiest week for auctions this year, compared with 63.3 per cent the previous week, and still well down from 74.1 per cent a year ago. Although Melbourne recorded its busiest week for auctions so far this year with a total of 1,653 homes taken to auction, the final auction clearance rate across the city fell to 68.7 per cent, down from the 70.8 per cent over the week prior. In Sydney, the final auction clearance rate increased to 64.8 per cent last week, from 62.2 per cent the week prior. Across the smaller auction markets, clearance rates improved in Brisbane, Perth and Tasmania, while Adelaide and Canberra both returned a lower success rate over the week. They say Geelong was the best performing non-capital city region last week, with 86.1 per cent of the 56 auctions successful. However, the Gold Coast region was host to the highest number of auctions (60). This week they are expecting a high 3,689 planned auctions today, so we will see where the numbers end up. I am still digging into the clearance rate question, and should be able to post on this soon. But remember that number, 3,689, because the baseline seems to shift when the results arrive.
Finally, The Royal Commission of course took a lot of air time this week, and I did a separate piece on the outcomes yesterday, so I won’t repeat myself. But suffice it to say, we think the volume of unsuitable mortgage loans out there is clearly higher than the lenders want to admit. Mortgage Broking will also get a shake out as we discussed on the ABC this week. And that’s before they touch on the wealth management sector!
We think there are a broader range of challenges for bankers, and their customers, as I discussed at the Customer Owned Banking Association conference this week. There is a separate video available, in which you can hear about what the future of banking will look like and the importance of customer centricity. In short, more disruption ahead, but also significant opportunity, if you know where to look. I also make the point that ever more regulation is a poor substitute for the right cultural values. At the end of the day, a CEO’s overriding responsibility is to define the right cultural values for the organisation, and the major banks have been found wanting. A quest for profit at any cost will ultimately destroy a business if in the process it harms customers, and encourages fraud and deceit. You simply cannot assume banks will do the right thing, unless the underlying corporate values are set right. Remember Greenspans testimony after the GFC, when he said “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
Markets are beginning to ask whether companies will be capable of passing on higher costs to the U.S.’ less than financially robust middle class, according to Moodys.
The U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a leveling off of global business activity.
Missing from last week’s discussion of a record ratio of U.S. nonfinancial-corporate debt to GDP was any mention of 2017’s near-record high ratio of total U.S. private and public nonfinancial-sector debt relative to GDP. The yearlong averages of 2017 showed $49.05 trillion of total nonfinancial-sector debt and $19.74 trillion of nominal GDP that put nonfinancial-sector debt at 249% of GDP—or just a tad under 2016’s record 250%.
The leveraging up of the U.S. economy has coincided with a downshifting of U.S. economic growth. From 1961 through 1979, U.S. real GDP expanded by an astounding 3.9% annually, on average, while total nonfinancial-sector debt approximated 133% of nominal GDP. When real GDP’s average annual rate of growth eased to the 3.2% of 1979-2000, the ratio of nonfinancial-sector debt to GDP rose to 176%. Since the end of 2000, U.S. economic growth has averaged only 1.8% annually and, in a possible response to subpar growth, nonfinancial-sector debt has soared to 232% of GDP
High Systemic Leverage Reins in Benchmark Yields
Over time, the record shows that the climb by the moving 10-year ratio of nonfinancial-sector debt to GDP has been accompanied by a declining 10-year moving average for the 10-year Treasury yield. For example, as the moving 10-year ratio of debt to GDP rose from 1997’s 183% to 2017’s 245%, the 10-year Treasury yield’s moving 10-year average fell from 7.31% to 2.59%.
Two factors may be at work. First, lower interest rates encourage an increase in balance-sheet leverage. Second, to the degree an elevated ratio of debt to GDP heightens the economy’s sensitivity to an increase in interest rates, lofty readings for leverage limit the upside for interest rates. Moreover, as shown by the historical record, if higher leverage tends to occur amid a slower underlying pace of economic growth, then the case favoring relatively low interest rates amid high leverage is strengthened.
None of this dismisses the possibility of an extended stay above 3% by the 10-year Treasury yield. Instead, today’s record ratio of debt to GDP warns of greater downside risk for business activity whenever interest rates enter into a protracted climb.
Today we examine the Mortgage Industry Omnishambles. And it’s more than just a flesh wound!
Welcome to the Property Imperative Weekly to 17th March 2018. Watch the video, or read the transcript.
In this week’s review of property and finance news we start with the latest January data from the ABS which shows lending for secured housing rose 0.14% or 28.8 million to $21.1 billion. Secured alterations fell 1%, down $3.9 million to $391 million. Fixed personal loans fell 0.1%, down $1.2 million to $4.0 billion, while revolving loans fell 0.06%, down $1.3 million to $2.2 billion.
Investment lending for construction of dwellings for rent rose 0.86% or $10 million to $1.2 billion. Investment lending for purchase by individuals fell 1.34%, down $127.7 million to $9.4 billion, while investment lending by others rose 7.7% up $87.2 million to $1.2 billion.
Fixed commercial lending, other than for property investment rose 1.25% of $260.5 million to $21.1 billion, while revolving commercial lending rose 2.5% or $250 million to $10.2 billion.
The proportion of lending for commercial purposes, other than for investment housing was 45% of all commercial lending, up from 44.5% last month.
The proportion of lending for property investment purposes of all lending fell 0.1% to 16.6%.
So, we are seeing a rotation, if a small one, towards commercial lending for more productive purposes. However, lending for property and for investment purposes remains quite strong. No reason to reduce lending underwriting standards at this stage or weaken other controls.
But this also explains the deep rate cuts the banks are now offering – even to investors – ANZ Bank and the National Australia Bank were the last of the big four to announce cuts to their fixed rates, following similar announcements from the Commonwealth Bank and Westpac. NAB has dropped its five-year fixed rate for owner-occupied, principal and interest home loans by 50 basis points, from 4.59 per cent to 4.09 per cent. The bank has also reduced its fixed rates on investor loans by up to 35 basis points, with rates starting from 4.09 per cent. And last week ANZ also dropped fixed rates on its “interest in advance”, interest-only home loans by up to 40 basis points, with rates starting from 4.11 per cent. Further, fixed rates on its owner-occupied, principal and interest home loans have fallen by 10 basis points, with rates now starting from 3.99 per cent. This fixed rate war shows our big banks are not pricing in a rate hike anytime soon.
But we think these offers will likely encourage churn among existing borrowers, rather than bring new buyers to the market. For example, the ABS housing finance data showed that in original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments rose to 18.0% in January 2018 from 17.9% in December 2017 – and this got the headline from the real estate sector, but the absolute number of first time buyers fell, thanks mainly to falls of 22.3% in NSW and of 13.3% in VIC. More broadly, there were small rises in refinancing and investment loans for entities other than individuals.
The latest data from CoreLogic shows home prices fell again this week, with Sydney down for the 27th consecutive week, and their index registering another 0.09% drop, whilst auction volumes were down on last week. They say that last week, the combined capital city final auction clearance rate fell to 63.3 per cent across a lower volume of auctions with 1,764 held, down from the 3,026 auctions over the week prior when a slightly higher 63.6 per cent cleared. The weighted average clearance rate has continued to track lower than results from last year; when over the corresponding week 75.1 per cent of the 1,473 auctions sold.
But the strategic issues this week relate to the findings from the Royal Commission and from the ACCC on mortgage pricing. I did a separate video on the key findings, but overall it was clear that there are significant procedural, ethical and even legal issue being raised by the Commission, despite their relatively narrow terms of reference. They cannot comment on bank regulation, or macroprudential, but the Inquiries approach is to examine a series of case studies, from the various submissions they have received, and then apply forensic analysis to dig into the root causes examining misconduct. The question of course is, do the specific examples speak to wider structural questions as we move from the specific instances. We discussed this on ABC Radio this week.
From NAB we heard about referrer’s providing leads to the Bank, outside normal lending practices and processes, and some receiving large commissions, despite not being in the ambit of the responsible lending code. From CBA we heard that the bank was aware of the conflict brokers have especially when recommending an interest only loan, because the trail commission will be higher as the principal amount is not repaid. And from Aussie, we heard about their reliance on lenders to trap fraud, as their own processes were not adequate. And we also heard of examples of individual borrowers receiving loans thanks to poor conduct, or even fraud. We also heard about how income and expenses are sometimes misrepresented. So, the question is, do these various practices show up more widely, and what does this say about liar loans, and mortgage systemic risk?
We always struggled to match the data from our independent household surveys with regards to loan to income, and loan to value, compare with loan portfolios we looked at from the banks. Now we know why. In some cases, income is over stated, expenses are understated, and so loan serviceability is a potentially more significant issue than the banks believe – especially if interest rates rise. In fact, we saw very similar behaviours to the finance industry in the USA before the GFC, suggesting again we may see the same outcomes here. One other point, every lender is now on notice that they need to look at their current processes and back book, to test affordability, serviceability and risk. This is a big deal.
I will also be interested to see if the Commission turns to look at foreclosure activity, because this is the other sleeper. Mortgage delinquency in Australia appears very low, but we suspect this is associated with heavy handed forced sales. Something again which was apparent around the GFC.
More specifically, as we said in a recent blog, the role and remuneration models for brokers are set for a significant shakedown.
Turning to the ACCC report on mortgage pricing, this was also damming. Back in June 2017, the banks indicated that rate increases were primarily due to APRA’s regulatory requirements, but now under further scrutiny they admitted that other factors contributed to the decision, including profitability. Last December, the ACCC was called on by the House of Representatives Standing Committee on Economics to examine the banks’ decisions to increase rates for existing customers despite APRA’s speed limit only targeting new borrowers. The investigation falls under the ACCC’s present enquiry into residential mortgage products, which was established to monitor price decisions following the introduction of the bank levy. Here are the main points.
Banks raised rates to reach internal performance targets: concern about a shortfall relative to performance targets was a key factor in the rate hikes which were applied across the board. Even small increases can have a significant impact on revenue, the report found. And the majority of existing borrowers would likely not be aware of small changes in rates and would therefore be unlikely to switch.
A shared interest in avoiding disruption: Instead of trying to increase market share by offering the lowest interest rates, the big four banks were mainly preoccupied and concerned with each other when making pricing decisions. It shows a failure in competition (my words).
Reputation is everything: The banks it seems were very conscious of how they should explain changes. As it happens, blaming the regulators provides a nice alibi/
For Profit: Internal memos also spoke of the margin enhancement equating to millions of dollars which flowed from lifting investment loans.
New Loans are cheaper, legacy rates are not. Banks of course are offering deep discounts to attract new customers, funded by the back book repricing. The same, by the way, is true for deposits too.
The Australian Bankers Association “silver lining” statement on the report said they welcomed the interim report into residential mortgages, which clearly shows very high levels of discounting in the Australian home loan market. It’s clear that competition is delivering better deals for customers, shopping around works and Australians should continue to do so to get the best discounts on the advertised rate. But they are really missing the point!
We will see if the final report changes, but if not these are damming, but not surprising, and again shows the pricing power the major lenders have.
So to the question of future rate rises. The FED meets this week, and the expectation is they will lift rates again, especially as the TRUMP tax cuts are inflationary, at a time when the US economy is already firing. In a recent report Fitch Ratings said that Central banks are becoming less cautious about normalising monetary policy in the face of strong growth and diminishing spare capacity. They expect the Fed to raise rates no less than seven times before the end of next year. And while still sounding tentative, the European Central Bank is clearly laying firm groundwork for phasing out QE completely later this year. They now also expect the Bank of England to raise rates by 25bp this year.
Guy Debelle, RBA Deputy Governor spoke on “Risk and Return in a Low Rate Environment“. He explored the consequences of low rates, on asset prices, and asks what happens when rates rise. He suggested that we need to be alert for the effect the rise in the interest rate structure has on financial market functioning, and that investors were potentially too complacent. There are large institutional positions that are predicated on a continuation of the low volatility regime remaining in place. He had expected that volatility would move higher structurally in the past and this has turned out to be wrong. But He thinks there is a higher probability of being proven correct this time. In other words, rising rates will reduce asset prices, and the question is – have investors and other holders of assets – including property – been lulled into a false sense of security?
All the indicators are that rates will rise – you can watch our blog on this. Rising rates of course are bad news for households with large mortgages, exacerbated by the possibility of weaker ability to service loans thanks to fraud, and poor lending practice. We discussed this, especially in the context of interest only loans, and the problems of loan resets on the ABC’s 7:30 programme on Monday. We expect mortgage stress to continue to rise.
There was more discussion this week on Housing Affordability. The Conversation ran a piece showed that zoning is not the cause of poor affordability, and neither is supply of property. Indeed planning reform they say is not a housing affordability strategy. Australia needs a more realistic assessment of the housing problem. We can clearly generate significant dwelling approvals and dwellings in the right economic circumstances. Yet there is little evidence this new supply improves affordability for lower-income households. Three years after the peak of the WA housing boom, these households are no better off in terms of affordability. In part, this may reflect that fact that significant numbers of new homes appear not to house anyone at all. A recent CBA report estimated that 17% of dwellings built in the four years to 2016 remained unoccupied. If we are serious about delivering greater affordability for lower-income Australians, then policy needs to deliver housing supply directly to such households. This will include more affordable supply in the private rental sector, ideally through investment driven by large institutions such as super funds. And for those who cannot afford to rent in this sector, investment in the community housing sector is needed. In capital city markets, new housing built for sale to either home buyers or landlords is simply not going to deliver affordable housing options unless a portion is reserved for those on low or moderate incomes.
But they did not discuss the elephant in the room – booming credit. We discussed the relative strength of different drivers associated with home price rises in a separate, and well visited blog post, Popping The Housing Affordability Myth. But in summary, the truth is banks have pretty unlimited capacity to create more loans from thin air – FIAT – let it be. It is not linked to deposits, as claimed in classic economic theory. The only limit on the amount of credit is people’s ability to service the loans – eventually. With that in mind, we built a scenario model, based on our core market model, which allows us to test the relationship between home prices, and a series of drivers, including population, migration, planning restrictions, the cash rate, income, tax incentives and credit.
We found the greatest of these is credit policy, which has for years allowed banks to magic money from thin air, to lend to borrowers, to drive up home prices, to inflate the banks’ balance sheet, to lend more to drive prices higher – repeat ad nauseam! Totally unproductive, and in fact it sucks the air out of the real economy and money directly out of punters wages, but make bankers and their shareholders richer. One final point, the GDP calculation we use in Australia is flattered by housing growth (triggered by credit growth). The second driver of GDP growth is population growth. But in real terms neither of these are really creating true economic growth. To solve the property equation, and the economic future of the country, we have to address credit. But then again, I refer to the fact that most economists still think credit is unimportant in macroeconomic terms! The alternative is to continue to let credit grow well above wages, and lift the already heavy debt burden even higher. Current settings are doing just that, as more households have come to believe the only way is to borrow ever more. But, that is, ultimately unsustainable, and this why there will be an economic correction in Australia, and quite soon. At that point the poor mortgage underwriting chickens will come home to roost. And next time we will discuss in more detail how these scenarios are likely to play out. But already we know enough to show it will not end well.
Interesting speech from Guy Debelle, RBA Deputy Governor “Risk and Return in a Low Rate Environment“. He explores the consequences of low rates, on asset prices, and asks what happens when rates rise. He suggests that we need to be alert for the effect the rise in the interest rate structure has on financial market functioning.
The recent spike in volatility is one example of this. This was a small example of what could happen following a larger and more sustained shift upwards in the rate structure. The recent episode was primarily confined to the retail market. The large institutional positions that are predicated on a continuation of the low volatility regime remain in place. He has expected that volatility would move higher structurally in the past and this has turned out to be wrong. But He thinks there is a higher probability of being proven correct this time.
In other words, rising rates will reduce asset prices, and the question is have investors and other holders of assets – including property – been lulled into a false sense of security?
Here is the speech:
Low Interest Rates
I am going to use the rate structure in the US, and particularly the yield on a US 10-year Treasury bond to illustrate the shift in the rate structure (Graph 1).
As you are all aware, in the wake of the financial crisis and the sharp decline in global growth and inflation, monetary policy rates round the world were reduced to historically low levels. In a number of countries (Australia being one notable exception), the policy rate was lowered to its effective lower bound, which in some cases was even in negative territory.
In part reflecting the low level of policy rates and the slow nominal growth post crisis, long-term bond yields also declined to historically low levels. 10-year government bond yields in some countries, including Germany, Japan and Switzerland have been negative at various times in recent years. In 2015, over US$14 trillion of sovereign paper had negative yields.
For the past decade, the yield structure in the US has been lower than at any time previously. Let me put in context the current excitement about the 10-year yield in the US reaching 3 per cent. In the three decades prior to 2007, the low point for the yield was 3.11 per cent.
All this goes to say that we have been living in a period of unusually low nominal bond yields. How long will this period last?
One way to think about this question is to ask whether what we are seeing is the realisation of a tail event in the historical distribution of interest rates. While this tail event has now lasted quite a long time, if you thought it was a tail event, then you would expect yields to revert back to their historical mean at some point. You also wouldn’t change your assessment of the distribution of future realisation of interest rates.
On the other hand, it might be the case that the yield structure has shifted to a permanently lower level because of (say) secular stagnation resulting in structurally lower growth rates for the major economies for the foreseeable future. If this were the case, you would change your assessment of future interest rate outcomes.
I don’t know the answer to this question, but it has material implications for asset pricing.
As I said earlier, the prices of many assets could be broadly validated if you believe the low rate structure is here to stay. This is because the lower rate structure means that the rate with which you discount expected future returns on your asset is lower and hence the asset price is higher for any given flow of future earnings.
The current constellation of asset prices seems to be based on the view that the global economy can grow strongly, with associated earnings growth, but that strong growth will not lead to any material increase in inflationary pressure.
You might want to question how long such a benign conjuncture could last. Current asset pricing suggests that the (average) expectation of market participants is that it will last for quite a while yet.
It is also worth pointing out that it is possible that a move higher in interest rates occurs alongside higher expected (nominal) dividends because of even higher real growth. If this were to occur it would not necessarily imply that asset prices have to adjust. It would depend upon the relative movements in earnings expectations and interest rates; that is, the numerator and denominator in the asset price calculation.
How might we know whether the distribution of interest rates has shifted? One can think of the interest rate distribution as being anchored by the neutral rate of interest. I talked about this in the Australian context last year. As I said then, empirically the neutral rate of interest is difficult to estimate. It is even harder to forecast. The factors which affect it are often slow moving. But sometimes they aren’t, most notably around the time of the onset of the financial crisis in 2007-08, when estimates of the neutral rate declined rapidly and significantly. Currently, there is a debate in the US as to whether the neutral rate of interest has bottomed and is shifting up. This raises the question as to the degree and speed with which such a movement in the neutral rate in the US might translate globally.
All of these questions highlight to me the inherent uncertainty about the future evolution of interest rates. One might decide that interest rates are going to continue to remain lower for longer, but I struggle to see how one can hold that view with any great certainty. Yet there appears to me to be very little, if any, compensation for this uncertainty in fixed income markets. Most estimates of the term premium in the 10-year US Treasuries are around zero, or are even negative (Graph 2). Investors are not receiving any additional compensation for holding an asset with duration.
That is, one can have different views about the longevity of the current rate structure. But, in part reflecting these different views about longevity as well as the unusual nature of the current environment, there is a significant degree of uncertainty about the future. Yet many financial prices do not obviously offer any compensation for that uncertainty.
It’s not only in the term structure of interest rates where compensation for uncertainty is low. Measures of implied volatility indicate that compensation for uncertainty about the path of many other financial prices is also low, and has been low for some time. This has been true across short and long time horizons, across countries, including Australia, across asset classes, and across individual sectors within markets (Graph 3 and 4). I will discuss some of the possible explanations for this, drawing on material published in the RBA’s February Statement on Monetary Policy, and also discuss the recent short-lived spike in volatility in equity markets.
Implied volatility is derived from prices of financial options. Just as the term premium measures compensation for uncertainty about the future path of interest rates, implied volatility reflects uncertainty about the future price of the asset(s) underlying a financial option. The more certain an investor is of the future value of the underlying asset, or the higher their risk tolerance, the lower the volatility implicit in the option’s price will be.
Thus, one interpretation of the recent low level of volatility is that market participants have been more confident in their estimates of future outcomes. This is consistent with the observed reduction in the variability of many macroeconomic indicators, such as GDP and inflation, and a decline in the frequency and magnitude of the revisions that analysts have made to their forecasts of such variables (Graph 5). Given the importance of these variables as inputs into the pricing of financial assets, it’s no surprise that greater investor certainty about their future values has in turn given investors more certainty about the future value of asset prices.
As you can see from all three graphs, a similar degree of certainty about the future was present in the mid 2000s, when there was a high degree of confidence that the ‘Great Moderation’ was going to deliver robust growth and low inflation for a number of years to come.
Monetary policy is also an important input into the pricing of financial assets, so a reduction in the perceived uncertainty around central bank policy settings may also have contributed to low financial market volatility. Monetary policy settings have been relatively stable in recent years, and where central banks have adjusted interest rates or their purchases of assets, these changes have tended to be gradual and clearly signalled in advance. Central banks have also made greater use of forward guidance as a policy tool to attempt to provide more certainty about the path of monetary policy.
But while central banks might act gradually and provide this guidance, the market doesn’t have to believe the guidance will come to pass. There are any number of instances in the past where central bank forward guidance didn’t come to pass. In my view, it is more important for the market to have a clear understanding about the central bank’s reaction function. That is, how the central bank is likely to adjust the stance of policy as the macroeconomic conjuncture evolves. If that is sufficiently clear, then forward guidance does not obviously have any large additional benefit, and runs the risk of just adding noise or sowing confusion.
Hence an explanation for the low volatility could be the assumption of a stable macro environment together with an understanding of central bank reaction function, rather than the effect of forward guidance per se.
The low level of implied volatility could also reflect greater investor willingness to take on financial market risk. This is consistent with measures that suggest demand for derivatives which protect against uncertainty has declined. It is also consistent with other indicators of increased investor appetite for financial risks, such as the narrowing of credit spreads. This increased risk appetite may in part reflect the low yield environment of recent years; protection against uncertainty is not costless, and so detracts from already low returns.
There has also been an increased interest in the selling of volatility-linked derivatives by investors to generate additional returns in the low yield environment in recent years. Effectively, some market participants were selling insurance against volatility. They earned the premium income from those buying the insurance whilever volatility remains lower than expected, but they have to pay out when volatility rises. In recent years, there was a steady stream of premium income to be had. (This is even more so if I were a risk neutral seller of insurance to a risk-averse buyer, in which case, the expected value of the insurance should be positive.) But the payout, when it came, was large. I will come back to this shortly in discussing recent developments.
This reduced demand for volatility insurance combined with increased supply saw the price fall.
Such an extended period of low volatility is not unprecedented, although the recent episode was among the longest in several decades (Graph 6). Prolonged periods of low volatility have sometimes been followed by sudden increases in volatility – although generally not to especially high levels – and a repricing of financial assets. A rise in volatility could be associated with a reassessment of economic conditions and expected policy settings, in which case, one might not expect the rise to last that long. In contrast, a structural shift higher in volatility requires an increase in uncertainty about future outcomes, rather than simply a reassessment of them. But just as I find it puzzling that term premia in fixed income markets have been so low for so long, I similarly find it puzzling that measures of volatility do not seem to embody much uncertainty either.
The recent spike in volatility in early February is interesting in terms of the market dynamics, coming as it did after a prolonged period of low volatility.
From around September 2017, there had been a rise in bond yields, most notably in the US, as confidence about the outlook for the US and global economy continued to improve. This rise in yields accelerated in January 2018, again most notably in the US, in large part in response to the passage of the fiscal stimulus there. As Graph 7 shows, the rise in Treasury yields in the first part of this year reflected both a rise in real yields and compensation for inflation. This reassessment of the macroeconomic outlook was also reflected in a reassessment (albeit relatively small) of the future path of monetary policy in the US. It is also worth noting that the real yield can incorporate any risk premium on the underlying asset. So the recent rise may also be a result of a change in the assessment of investors about the riskiness of US Treasuries.
In light of the reassessment of the macro environment it was somewhat surprising that through the month of January, equity prices in the US rose as strongly as they did. As I discussed at the outset of this speech, I would expect that a shift upwards in the structure of interest rates would result in a repricing of asset prices more generally. In late January, this indeed is what happened: equity prices declined, again most sharply in the US. There was a sharp rise in volatility. The initial rise in volatility was exacerbated by the unwinding of a number of products that allowed retail investors (and others) to sell volatility insurance, and the hedging by the institutions that had offered those products to their retail customers. Indeed, unwinding is a euphemism as, in some cases, the retail investor lost all of their capital investment. Having seen the legendary Ed Kuepper and the Aints again last Friday, it’s worth remembering to “Know Your Product”, otherwise it will be “No, Your Product”.
What is particularly noteworthy about this episode is how much the rise in volatility, and the large movements in prices, was confined to equity markets. While volatility rose in other asset classes, it did not increase to particularly noteworthy levels. For example, there was relatively little spillover to emerging markets. This is in stark contrast to similar episodes in the past. The fact that these products were particularly associated with volatility in US equity prices appears to have contributed to the limited contagion. Also noteworthy is how short-lived the rise in volatility has been (to date). In discussions with market participants, one possible cause of this is that the unwinding of volatility positions has been largely confined to the retail market, which was relatively small in size. There does not seem to have been much adjustment in the volatility exposures of large institutional market participants to date.
That said, it is conceivable that this episode gives a foretaste of the sort of market dynamics that might occur if there were to be a further rise in yields as the market reassesses the outlook for output and, particularly, inflation.
Demand and Supply Dynamics
Another consideration in thinking about future developments in the yield structure is the balance of demand and supply in the sovereign debt market. It is often difficult to assess the degree of influence that demand and supply dynamics have on the market. But there are some noteworthy developments occurring at the moment that are worth highlighting.
Graph 8 shows the net new debt issuance by the governments of the US, the euro area and Japan, and the net purchases of sovereign debt by their respective central banks. It shows that the peak net purchases by the official sector occurred in 2016. This happens to coincide with the low point in sovereign bond yields, but I would not attribute full causation to that. The central bank purchases are a reaction to the macroeconomic conjuncture at the time which itself has a direct influence on the yield structure. That said, one of the main aims of the central bank asset purchases was to reduce the term premium.
But in 2018, there is going to be a net supply of sovereign debt to the market from the G3 economies for the first time since 2014. This reflects a few different developments. The Federal Reserve started the process of reducing the size of its balance sheet last year by not fully replacing maturing securities with new purchases. While this is a very gradual process, it is a different dynamic from the previous eight years. At the same time, the US Treasury will issue considerably more debt than in recent years to finance the US budget deficit, which has grown from 2 per cent of GDP in 2015 to over 5 per cent in 2019 as the Trump administration implements its sizeable fiscal stimulus.
In Europe, the fiscal position is gradually improving, but the ECB has started the process of scaling back its purchases of sovereign debt, with some expectation these might cease entirely at the end of the year. In Japan, the Bank of Japan is still undertaking very large purchases of Japanese Government debt, which are larger even than the sizeable net issuance to fund Japan’s fiscal deficit.
Meanwhile, there is no expectation of significant reserve accumulation by central banks or sovereign asset managers, which can often take the form of sovereign debt purchases. And financial institutions, which have been significant accumulators of sovereign bonds in recent years as they sought to build their liquidity buffers, are not expected to accrue liquid assets to the same extent again in the foreseeable future.
So the net of all of this is that some of the demand/supply dynamics in sovereign bond markets will be different this year from previous years. For a number of years, central banks purchased duration from the market, but that is in the process of reversing. In that regard, an issue worth thinking about is that the central banks don’t manage their duration risk in their bond holdings at all. Nor do they rebalance their portfolios in response to price changes, unlike most other investors whose actions to rebalance their portfolios back to their benchmarks act as a stabilising influence.
An additional issue worth thinking about is that, through its purchases of mortgage-backed securities, the US Federal Reserve removed much of the uncertainty associated with the early prepayment of mortgages by homeowners by absorbing the impact of prepayments on the maturity profile of its bond portfolio. Private investors typically hedge this risk, and their hedging activity contributes to volatility in interest rates. As the Fed winds down its balance sheet, it is putting this negative convexity risk back in the hands of private investors, and the associated interest rate volatility will return to the market.
Issuance in a Low Rate Environment
To date I have been discussing developments in the rate structure from the perspective of the investor. But it is also interesting to examine how issuers have responded to the historically low rate structure.
Graph 9 shows that many issuers have responded to the low rate structure, and particularly the absence of any material term premium, by lengthening the maturity of their debt, aka “terming out”. Moreover, lower interest rates on their new issuance have resulted in the average duration of their debt rising by even more.
The first two panels show that is true of most sovereigns. The Australian governments, Commonwealth and State, have proceeded along this path. The Australian Office of Financial Management (AOFM) has significantly extended the curve in Australia, by issuing out to a 30-year bond. A number of bonds have been issued well beyond the 10-year maturity, which was the standard end of the yield curve for a number of years. This has also helped state governments to increase the maturity of their issuance.
One interesting exception to the general tendency to term out their debt is the US Treasury, which is undertaking a sizeable amount of issuance at the short end of the curve.
Corporates have also termed out their debt. Some corporates have issued debt with maturities as long as 50 years, which is interesting for at least two reasons. Firstly, a 50-year bond starts to take on more equity-like features. Secondly, many corporates don’t even last 50 years.
The Australian banks have also availed themselves of the opportunity to term out their funding for relatively little cost. The recently implemented Net Stable Funding Ratio (NSFR) further incentivises them to do this. As my colleague Christopher Kent noted a couple of days ago, the average maturity of new issuance of the Australian banks has increased from five years in 2013 to six years currently (Graph 10). As with other issuers, this materially reduces rollover risk. The banks have been able to issue in size at tenors such as seven or ten years that they historically often thought to be unattainable at any reasonable price.
While the low rate structure has often been perceived to be a challenge from the investor point of view, it has been an opportunity for issuers to reduce their rollover risk by extending debt maturities.
The structure of interest rates globally has been at an historically low level for a number of years. This has reflected the aftermath of the financial crisis and the associated monetary policy response. If the global recovery continues to play out as currently anticipated, one would expect that the monetary stimulus will unwind, which would see at least the short-end of yield curves rise.
At the same time, there have been factors behind the low structure of interest rates which are difficult to understand completely and raise questions about its durability. I have discussed some of them here today. In particular, I find it puzzling that there is little compensation for duration in the rate structure. While there are explanations for why interest rates may remain low for a considerable period of time, there is minimal compensation for the uncertainty as to whether or not this will actually occur. At the same time, equity prices embody a view of the future that robust growth can continue without generating a material increase in inflation. Again, there is little priced in for the risk that this may not turn out to be true.
The ongoing improvement in the global economy, together with the fiscal stimulus in the US has caused some investors to question these views. If interest rates continue to rise without a similar rise in expectations about future earnings growth, one would expect to see a repricing of other assets, particularly equity markets. Such a repricing does not necessarily mean a major derailing of the global recovery, indeed it is a consequence of the recovery, but it may have a dampening effect.
In the early hours of the morning of 7 October 2016, the sterling-US dollar exchange rate fell by nearly 10% within around 40 seconds. Most of this movement was reversed within the ten minutes that followed. This was one of a series of such ‘flash’ episodes in major financial markets – that is sharp and short-lived movements in price, which vastly exceed perceived changes in economic fundamentals. It certainly didn’t fail to catch the eye of policymakers, or the media.
Chart 1 shows data taken from this platform around the episode:
The triangles show the prices at which individual transactions took place. Those in blue (pointing down) indicate transactions initiated by a participant seeking to sell sterling. Those in green (pointing up) indicate those initiated by an order to buy.
The shaded regions show the cumulative distribution of limit orders around these prices. Limit orders are unexecuted orders to buy or sell sterling posted by prospective traders.
The relative weight of the shading on the chart shows the quantity of limit orders between a given price and the limit orders to buy/sell at the highest/lowest prices (the ‘best bid/ask prices’). As might be expected, prices further from the best bid/ask are shaded in darker colours. This indicates that there lies a larger cumulative quantity of limit orders between them and the best bid/ask.
The black line shows the midpoint – or ‘mid-price’ – between the best bid/ask prices.
From this chart we can construct a rough narrative of events:
In the minute preceding the crash, between six and seven minutes past midnight (00:06:00 and 00:07:00 British Summer Time), there was quite a large depth of orders both to buy and sell sterling (£60 million of orders in the observed ten levels of price closest to the best bid and ask prices).
But at around 00:07:00, an imbalance started to develop – with the quantity of orders to sell sterling starting to exceed those to buy.
It was at this point that a rapid succession of trades took place in sterling, at rapidly declining prices.
This imbalance became particularly severe around 00:07:17 BST. This can be seen from the large white areas in the graph, which indicate there to be (close to) no orders to buy sterling. In the half minute that followed, market functioning was severely impaired, with large ‘gaps’ in price visible between trades.
The quantity of, and balance between, limit orders to buy/sell sterling recovered after about 30 seconds but deteriorated severely again after around one minute. Shortly after 00:09 BST, there was a further sharp reduction in orders to buy sterling (corresponding to another white area on the chart).
The order book started to increase in depth around 00:09:30 BST, around 150 seconds after the initial sharp movement in price.
Thankfully, the events of the night of 7 October 2016 were without lasting consequences for financial stability, or the integrity of the functioning of the market for sterling. Higher than usual volumes were observed during the day that followed, and measures of illiquidity (including bid-ask spreads) remained slightly elevated; but broader spill overs were generally limited.
That, however – understandably – hasn’t stopped the search for answers.
The blue bar in Chart 2 shows the range of estimates of change in price given by this model, when calibrated to past movements in the sterling dollar exchange rate. These imply that the observed orders to sell sterling during the flash episode are consistent with a decrease in the sterling-US dollar exchange rate of between 1.03% and 2.87%, depending on the precise choice of parameters.
Chart 2: The (in)consistency between observed changes in price and those expected given observed orders to buy/sell sterling
The dots in the right-hand columns compare these estimates with the observed decline in the exchange rate. The purple triangle shows that which took place early in the episode, between 00:07:00 and 00:07:15 (roughly step (2), above). The yellow square shows the peak-to-trough fall in sterling over the entirety of the episode.
From this we can see:
The initial fall in sterling, during the early part of the episode, of 1.8%, is consistent with the range of estimates based on the observed imbalance of orders. This suggests that the movement in price was consistent with the arrival of a large order to sell sterling.
But the larger change in price that occurred between 00:07:00 to 00:07:17 cannot be explained by expected price impact of trades alone.
Was there another factor at play?
That the overall fall in sterling so vastly exceeds that predicted by our model might suggest that some some other driver might have been at play.
The report by the BIS suggests a number of other factors that might have played a role in reducing available liquidity during the episode. These include the temporary withdrawal of some market participants from their role as market makers. This dynamic may have, in part, reflected the presence of staff with lower risk limits and appetite at some institutions at that time of day. An automatic pause in trading in sterling futures contracts may also have led to a reduction of liquidity in the cash market, because some market makers are thought to rely on futures as a guide to the price at which they offer to buy/sell currency in cash markets. It is, however, difficult to know what weight to place on these different explanations.
All else equal, such a reduction in liquidity would have increased the resulting fall in price beyond that estimated to be in line with observed trading volume.
The events of 7 October 2016 represented one of a series of flash events occurring in electronically traded markets. No such events have, as yet, had longer lasting consequences for market functioning or stability.
Nonetheless, policymakers have recently pointed to the clear onus on central banks and the regulatory community to understand developments in these markets, and how they behave during periods of stress.
This work represents one step in that effort.
Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees