Why the RBA needs to talk about future interest-rate policy

From The Conversation.

The Reserve Bank of Australia should follow the example of other central banks and be clearer about when and how rates will change, called “forward guidance”, to make its policy more effective.

At the moment the RBA follows an approach to implement monetary policy known as inflation targeting. This means it has a numerical target for inflation (an average 2-3% inflation over the medium term) and a framework to achieve that target (how it thinks monetary policy affects the economy, and how it communicates policy decisions).

Australia’s cash rate is at a historical low of 1.5%. So if there’s any adverse shock to our economy (for example, a large correction in house prices), the RBA would have little room to reduce the cash rate before getting to 0% – the zero lower bound on nominal interest rates.

At that point, you can’t cut rates anymore. Research shows economic shocks can have a more severe impact on economic activity when the policy rate is at, or near, zero.

Instead the RBA should be more explicit about the conditions that would lead to a rate change. Research shows this has stimulated economic recovery before.

How rates work at the moment

To understand forward guidance it helps to understand conventional thinking about monetary policy. The RBA controls inflation by adjusting the cash rate, which is the interest rate on overnight loans in the interbank market.

Changes in the cash rate change longer-term interest rates in the economy. These then influence households’ and businesses’ spending and investment plans. These decisions also determine demand and inflation.

For example, suppose inflation is below target. A cut in the cash rate reduces longer-term interest rates, which encourages people to buy goods and services (falls in long-term deposit rates and government bonds reduce the incentive to save) and invest (commercial and mortgage loans are cheaper). Rising demand sends prices up, which brings inflation back to target.

As with other central banks around the world, the RBA also explains the rationale for its policy decisions. For example, in the Statement of Monetary Policy, released four times a year, the bank sets out its assessment of current domestic and international economic conditions, along with an outlook for Australian inflation and output growth.

The purpose of these announcements is to enhance the credibility of the inflation target. If people trust the RBA will implement policy to achieve the inflation target, they will make plans around what they spend and how they price goods and services based on this. This makes inflation easier to control.

How being clearer about rates helps

While the RBA might not be able to influence the current cash rate, it can still influence longer-term rates by making announcements about its future policy decisions. Long-term interest rates usually change depending on what people expect of future cash rate changes.

So if monetary policy can influence these expectations, it can move long-term rates.

Of course, words are cheap. To make these declarations credible the RBA would need to communicate its plans for the future cash-rate, with modelling and forecasts justifying those plans.

Economists could then judge whether the RBA is meeting its objective through good luck or good policy. If it’s through good policy, it enhances the RBA’s credibility and, in a virtuous circle, this gives the bank policy more influence over expectations.

A prominent example of forward guidance comes from the United States’ central bank, the Federal Reserve. In December 2008, when the federal funds rate (the US equivalent of the Australian cash rate) was first at the zero lower bound, the Federal Reserve announced:

The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Translated, the Fed anticipated keeping the federal funds rate at zero for a considerable time. This communication was meant to influence the public’s expectations about the future course of US monetary policy, and to have consumers and businesses expect an expansionary monetary policy for some time.

During the recovery, the Fed refined its communication strategy to become more explicit about the economic circumstances that would lead to a change in policy. For example, in June 2013, the committee that sets rates anticipated that:

…this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-½%.

This type of announcement gives people more information about the strategy the Fed will take with rates, rather than simply providing forecasts about what it expects future economic conditions to be like (which doesn’t need to have any information about policy strategy).

Recent evidence confirms this had an impact on businesses’ expectations. Right after the June 2013 announcement by the Federal Reserve, there was an increase in the number of quarters until businesses expected the US policy rate to increase above 25 basis points.

FOMC= Federal Open Market Committee (which sets rates) Swanson and Williams: the zero bound and interest rates, Author provided

Other research also suggests forward guidance influenced private sector expectations and stimulated the economic recovery after the global financial crisis.

At the moment, the RBA doesn’t produce statements about future monetary policy and how this would change if the economic environment changed. But the bank could do this.

The RBA has the luxury to develop its communications policy during a time of economic calm, unlike the Federal Reserve, which was forced to experiment with new policies during the worst recession since the Great Depression.

If the RBA waits until a future crisis, it would limit the power forward guidance could have in our economy.

Efrem Castelnuovo, Principal Research Fellow, Melbourne Institute of Applied Economic and Social Research, and Professor of Economics, Department of Economics, University of Melbourne;
Bruce Preston, Professor of Economics, University of Melbourne; Giovanni Pellegrino, Postdoctoral Research Fellow, University of Melbourne

The Mortgage Industry Omnishambles – The Property Imperative 17 March 2018

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.

  1. 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.
  2. 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).
  3. 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/
  4. For Profit: Internal memos also spoke of the margin enhancement equating to millions of dollars which flowed from lifting investment loans.
  5. 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.

What Happens To Asset Prices As Rates Rise?

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).

Graph 1
Graph 1: 10-year US Treasury Yields

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.

Graph 2
Graph 2: 10-year US Treasury Term Premium

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.

Low Volatility

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.

Graph 3
Graph 3: Financial Market Volatility
Graph 4
Graph 4: Realised Volatility in Selected US Equity Sectors

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.

Graph 5
Graph 5: Macroeconomic Volatility

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.

Graph 6
Graph 6: Periods of Low US Equity Market Volatility

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.

Graph 7
Graph 7: 10-year US Treasury Yields

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.

Graph 8
Graph 8: Net Issuance of Sovereign Bondsnand Central Bank Purchases

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.

Graph 9
Graph 9: Bond Market Term to Maturity

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.

Graph 10
Graph 9: Maturity of Australian Banks’ Long-term Debt

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.

The RBA on NPP

From a speech by Michele Bullock RBA Assistant Governor (Financial System) – Address to Seamless Payments 2018.

As you know, the NPP launched to the public in mid February. It is the culmination of more than 5 years’ work from inception to launch. It involved unprecedented cooperation between financial institutions to build the capability to send and receive individual payment messages between themselves in real time, with settlement also occurring transaction-by-transaction through the Reserve Bank’s Fast Settlement Service. But it also required banks to upgrade their internal systems to allow posting to customer accounts within a few seconds. The resources involved in delivering the system as a whole were substantial.

Australia is obviously not the first country to build a fast payments system. FIS in its 2017 report on fast retail payment systems noted that there were some retail payment systems with real-time features as early as the 1970s and 1980s.[1] The report listed 25 countries with live real-time systems in 2017. It listed a further 10 systems under development, at that time including Australia. FIS also provided a useful taxonomy to compare and contrast the various systems – its Faster Payment Innovation Index (FPII). The index rates faster payment systems on the basis of the features they provide. At a basic level, in order to be classified as a fast payment service the system must provide interbank, account-to-account payments in less than one minute end-to-end and be irrevocable. But, the more value-added services and openness to innovation, the higher the rating.

The Australian NPP was not rated in this report since it was not live at the time. But it certainly will offer many of the features that rate highly in the FPII. For example, the taxonomy lists ISO standard and 24/7 availability as being highly desirable features enhancing customer value – the NPP offers both these. It lists fast settlement, the ability to include remittance information with payment and the ability to assign an alias to a bank account as being some of the optional features that maximise customer value. The NPP also delivers these features. There are other capabilities that the NPP does not currently provide – like ‘pull payment’ capability – but the infrastructure will allow other services to be offered in the future.

One of the things that is unique about our NPP is the architecture. There are three facets to this. The first is that the infrastructure for exchanging messages is based on a distributed architecture rather than a centralised hub. Participating institutions implement payment gateways that exchange messages with other payment gateways. There is no centralised infrastructure that processes and switches messages. One key advantage of this architecture is that there is no central point of failure. It also means that many of the functions that might typically be performed in a hub, such as fraud monitoring and exceptions processing, are done by the individual participants. This might be desirable for institutions that want to maintain control over these processes.

The second facet of the architecture that is quite innovative is the separation of the clearing and settlement infrastructure from commercial overlays. The infrastructure has been set up as a utility, and pricing will be on a cost recovery basis. This infrastructure can then be utilised by any number of commercial ‘overlays’ to deliver services that use the NPP’s real-time clearing and settlement capabilities. The first of these is Osko – initially offering person-to-person payments but within a year or so offering payment with document and request to pay. It is also expected that other innovative services will look to leverage the real-time payment capability of the NPP.

The third relatively unusual facet is the real-time transaction-by-transaction settlement of retail payments 24 hours a day, 7 days a week. Australia has had a real-time gross settlement system for high-value payments for weekday settlements for the past 20 years. And this is indeed best practice around the world for high-value payments. But not many countries currently provide real-time settlement of retail payments, and even fewer offer it 24/7. Many fast retail payments services, for example, settle payments in batches through the day or only during business hours. The advantage of utilising real-time settlement in our fast payment service is that it extinguishes settlement risk and removes the need for other controls over settlement risk, such as caps on exposures. The fact that these controls are not required removes some limitations that might otherwise need to be considered by overlay service providers as they design their products.

So now we have this world-class infrastructure, what for the future?

The first point to note is that it is still early days. Given the complexity of the build and the long-term nature of this important piece of infrastructure, the launch was never intended to be a ‘big bang’. While there had been extensive testing ahead of launch, including an extended period of live proving, moving into production always uncovers some issues. A cautious approach to ramping up volumes was therefore an appropriate way to manage the operational risks.

Second, the experience of fast payment systems around the world suggests that volumes will increase quite slowly at first. It took the UK Fast Payment Service around 3½ years to get to 10 transactions per person per annum and Swish, the Swedish system, just under 3 years to get to this level. There are probably a couple of reasons for the initially relatively slow growth in volumes. It will take some time for people to become familiar with the new system – people are typically quite set in their payment habits. Furthermore, like all networks, there are positive externalities the more participants there are. That is, as more financial institutions offer fast payments and the reach of the system grows, it provides greater value to both individuals and businesses. If none of my family and friends can receive payments through the NPP I am less likely to sign up for an alias and use it. But the more people I can pay using the system (and the more people I can receive money from) the higher value I get from the system.

Graph 2
Graph 2: Use of Fast Payments Systems


Third, as noted earlier, the system has been set up to encourage the development of commercial ‘overlays’ using the real-time payment capability to deliver value-added services to consumers and businesses. Aside from the additional Osko services in prospect, possible overlays might include services for superannuation, e-invoicing and motor vehicle sales. I am sure there are many innovative minds turning to the possibilities.

This brings me to an issue that has caused some concern among potential new players in this space – access to the NPP. They observe that the system has been built by the financial institutions and is governed by a board made up of those institutions, including the four major banks. They worry that these institutions will either make participation very difficult or costly or, alternatively, will have the inside running on developing and launching commercial overlay services.

I think there are a few reasons to be optimistic that access will not be an issue. To begin with, as I noted earlier, the NPP is a utility. It is aiming to cover costs, not make a profit. Further, given that many of its costs are fixed, it is in the interests of NPP Australia (NPPA) to get as many payments through the system as possible to lower the per-transaction cost.

The structure of the board and the constitution also provide some protection. The board is comprised of eight participant financial institutions (the four major banks plus four elected representatives of smaller institutions), two independent non-executive directors (of which one is chair) plus a director representing the Reserve Bank. Each director has one vote and the constitution notes that an objective of NPPA is to promote the public interest, including through fair access.

But it is also worth noting that the NPP at its core is an infrastructure that facilitates clearing of payment messages between financial institutions and settlement of those obligations across accounts at the Reserve Bank. In this sense, it is similar to other clearing and settlement systems – cheques, direct entry or payment cards, for example. It is not necessary, or even necessarily efficient, for all financial institutions to participate directly in clearing and settlement. In the NPP, for example, there are three aggregators that provide indirect access to institutions that do not want to incur the cost of participating directly. Indeed, there are already around 50 smaller banks, credit unions and building societies that are able to offer fast payments to their customers using the aggregators.

Similarly, it is not necessary for non-financial institutions that want to use the real-time capability of the NPP to participate directly in clearing and settlement. Just as they use the rails of other payment systems through a financial institution to offer their services to customers, they will be able to use the NPP. NPPA is already engaging with start-ups on how they might utilise the infrastructure. More generally, if a business doesn’t like the price for fast payments it is getting from its bank, there are many other institutions that can offer an alternative.

In the end, though, if it looks as though lack of access is stifling competition, the Reserve Bank has the power to designate and set an access regime. As I said, I am fairly optimistic that we will not have to. But it is always an option.


Planning Zones Cause Property Prices To Rise – RBA

An interesting  research paper from the Economic Research Department RBA “The Effect of Zoning on Housing Prices” is worth reading.

Overall, they suggest that development restrictions (interacting with increasing demand) have contributed materially to the significant rise in housing prices in Australia’s largest cities since the late 1990s, pushing prices substantially above the supply costs of their physical inputs.

Although differences in the value of dwelling structures and the physical value of land account for some of the variation in average housing prices across the four cities, zoning effect estimates account for the majority of the differences.

There is also a large gap opening up between apartment sale prices and construction costs over recent years, especially in Sydney. This suggests that zoning constraints are also important in the market for high-density dwellings.

They estimate that zoning restrictions raise detached house prices by 73 per cent of marginal costs in Sydney, 69 per cent in Melbourne, 42 per cent in Brisbane and 54 per cent in Perth.

This is not the amount that house prices would fall in the absence of zoning. Physical land costs are higher in Australian cities (particularly Sydney) than overseas. So even if zoning restrictions were relaxed, housing in Australia would remain expensive relative to cities where zoning is permissive and land is less physically scarce.

Using data from CoreLogic and some supply/dremand modelling they track the difference between the average (or market) price and the marginal (or physical) value of land.  Some government policies, – “zoning”, restrict the supply of housing.

Examples include minimum lot sizes, maximum building heights and planning approval processes. Although these restrictions may confer benefits, they also raise the price of housing. This paper attempts to quantify the effect of zoning on housing prices in Australia’s four largest cities.

Anecdotal evidence suggests that zoning can have a huge effect on land values. For example, a 363 hectare site in Wyndam Vale (40 km west of Melbourne) increased in value from $120 million to $400 million following its rezoning from rural to residential (Schlesinger and Tan 2017). Examples like this are common – Appendix A provides more. Such large increases in values as a result of zoning changes are inconsistent with the view that a physical shortage of land itself is the main cause of high land values and housing prices – and instead point towards a high ‘shadow price’ of government permission to build dwellings as a likely explanation. It is difficult, however, to gauge how representative these anecdotes are, or to analyse how they change over time or place.

To estimate the effect of zoning, we consider the cost of a marginal increase in the number and density of dwellings for a given area and given population (hence a reduction in average household size). This means that we do not include the costs involved in increasing the footprint or size of a city, such as provision of extra roads and utilities, as a cost of supplying housing.

Figure 2 shows a decomposition of property prices back to 1999. To extend our estimates of structure value back in time, we adjust the estimates from Table 1 by movements in the producer price index (PPI) – output of house construction series for each city’s corresponding state, and by movements in the average floor area of houses sold in each city. To estimate the value of physical land over time, we estimate separate regressions for each year back to 1999.

Figures 3–4 show estimates of the zoning effect for the average property in local government areas (LGAs). We split property prices into structure values and land values in each LGA, using the CoreLogic data on property prices and the valuer general estimates for land values for each LGA (as this allows structure value to vary across LGAs for reasons other than just floor area).19 We then estimate physical land values by running separate hedonic regressions for each LGA of the form of our large regression in Section 4.20 Our estimate of the zoning effect by LGA is then the remaining portion of land value not accounted for by the physical value.


If housing demand continues to grow, as seems likely, then existing zoning restrictions will bind more tightly and place continuing upward pressure on housing prices. Policy changes that make zoning restrictions less binding, whether directly (e.g. increasing building height limits) or indirectly, via reducing underlying demand for land in areas where restrictions are binding (e.g. improving transport infrastructure), could reduce this upward pressure on housing prices.

RBA Holds Once Again

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

The global economy has strengthened over the past year. A number of advanced economies are growing at an above-trend rate and unemployment rates are low. Growth picked up in the Asian economies in 2017, partly supported by increased international trade. The Chinese economy continues to grow solidly, with the authorities paying increased attention to the risks in the financial sector and the sustainability of growth.

The pick-up in the global economy has contributed to a rise in oil and other commodity prices over the past year. Even so, Australia’s terms of trade are expected to decline over the next few years, but remain at a relatively high level.

Globally, inflation remains low, although higher commodity prices and tight labour markets are likely to see inflation increase over the next couple of years. Long-term bond yields have risen but are still low. Market volatility has increased from the very low levels of last year. As conditions have improved in the global economy, a number of central banks have withdrawn some monetary stimulus. Financial conditions remain expansionary, with credit spreads narrow.

The Bank’s central forecast is for the Australian economy to grow faster in 2018 than it did in 2017. Business conditions are positive and non-mining business investment is increasing. Higher levels of public infrastructure investment are also supporting the economy. Further growth in exports is expected after temporary weakness at the end of 2017. One continuing source of uncertainty is the outlook for household consumption. Household incomes are growing slowly and debt levels are high.

Employment grew strongly over the past year and the unemployment rate declined. Employment has been rising in all states and has been accompanied by a significant rise in labour force participation. The various forward-looking indicators continue to point to solid growth in employment over the period ahead, with a further gradual reduction in the unemployment rate expected. Notwithstanding the improving labour market, wage growth remains low. This is likely to continue for a while yet, although the stronger economy should see some lift in wage growth over time. Consistent with this, the rate of wage growth appears to have troughed and there are reports that some employers are finding it more difficult to hire workers with the necessary skills.

Inflation remains low, with both CPI and underlying inflation running a little below 2 per cent. Inflation is likely to remain low for some time, reflecting low growth in labour costs and strong competition in retailing. A gradual pick-up in inflation is, however, expected as the economy strengthens. The central forecast is for CPI inflation to be a bit above 2 per cent in 2018.

On a trade-weighted basis, the Australian dollar remains within the range that it has been in over the past two years. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.

The housing markets in Sydney and Melbourne have slowed. Nationwide measures of housing prices are little changed over the past six months, with prices having recorded falls in some areas. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. APRA’s supervisory measures and tighter credit standards have been helpful in containing the build-up of risk in household balance sheets, although the level of household debt remains high.

The low level of interest rates is continuing to support the Australian economy. Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Another RBA Mortgage Data Rat?

The RBA has quietly revised down the household debt to income ratio stats contained in E2 statistical releases and their chart pack. It has dropped by 6% from 199.7 down to 188.4.

This is on top of the reduction in the growth in investment mortgages we discussed before.

More rubbery numbers, we suspect trying to play down the size of the mortgage debt problem.  RBA please explain!

This is the original chart from February (199.7).

This is the revised version, now available from the RBA site. Also they changed the scale, so it looks better too!

Now, we happen to retain the previous versions of the underlying RBA E2 series which by the way is derived from the ABS data series, and massaged by the RBA.  Household debt is sourced from ABS Cat No 5232.0. Debt includes debt owed by unincorporated enterprises, and does not appear to have changed.

We can track the changes the RBA made to the series. Last months figure dropped a magical 6%, to 188.4. It runs right across the series. The blue line is the original series, the orange one the revision.

This may have something to do with superannuation accounts, but unless I missed it, there has been no explanation of the changes.

If you know why it changed, do let me know!

UPDATE: I spoke to the RBA.  “The ABS made an error in the original release of the Financial Accounts (on the 20/12/2017) and subsequently revised the data on 1 February 2018. Details of the revisions are provided here”. The RBA’s statistical tables were consequently updated for the revisions on 2 February 2018.

This is what the ABS said: 01/02/2018: This release incorporates amendments to the household and general government (national and state and local) accounts payable and total liability series; and household net worth. The amendments are due to a correction to the implementation of an update of the Australian Accounting Standards Board (AASB 1056 Superannuation Entities) which relates to superannuation funds recognising for the first time employer sponsor receivables for Public Sector defined benefit schemes. The household and superannuation assets were correctly reported; however the counterparty to the superannuation receivable asset had been reported as a payable from household rather than general government. The mis-allocation occurred from September quarter 2016 onwards, when the update to AASB 1056 occurred.

This has been corrected in 9 excel tables. The impacted tables are Table 14, Table 18, Table 27, Table 29, Table 31, Table 33, Table 34, Table 35 and Table 49. The household sector summary and the sectoral analysis have been updated accordingly. The correction will also be included in the RBA household debt to income ratio which is calculated using ABS data. This will be published on the RBA website.

Weird it corrects the series back to the year 2000 and before.

More On The RBA Tweaks – Messy Or What!

I did a mapping between the old and new basis for investor and interest only loans in the RBA credit aggregates. I posted the data earlier.

Since mid-2015 the bank has been writing back perceived loan reclassifications which pushed the investor loans higher and the owner occupied loans lower.

They have now reversed this policy, so the flow of investment loans is lower (and more in line with the data from APRA on bank portfolios). Investor loans are suddenly 2% lower. Magically!

This is the monthly switching:

But two points.

First I am amazed the  banks feels its OK to suddenly change the basis of their calculations, when its such a critical issue. The provided reasoning is perverse – loan switching is “normal”. Suddenly back tracking over the past two years is plain weird.  The section in the Stability Report said it was going to happen. That is all.

Second, it once again highlights the rubbery nature of the data on lending in Australia. What with data problems in the banks, and at the RBA, we really do not have a good chart and compass.  It just happens to be the biggest threat to financial stability but never mind.

Standing back though, despite the static growth in investment lending, do not forget that overall debt is still rising faster than incomes, by a factor of two to three times.

Owner occupied lending must be tamed too if we are to ever get back to a more even keel – the case for more macro-prudential intervention just got stronger!

RBA Aggregate Lending Data Tweaked To Make Investor Loans Lower

The RBA has published their credit aggregates for January today. Owner occupied lending rose 0.6%, or 8% over the past year to $1.14 trillion. Investment lending rose 0.2% of 3% over the past year to $587 billion. It comprises 34% of all housing lending.  They changed the way they report the data this month. It changes the trend reporting significantly .

Business investment fell 0.1% in the month, or 3.4% over the past year to $908 billion. Personal credit rose 0.1%, but fell 0.9% over the past year to $151.5 billion.

The monthly movements show the clear slowing of the mortgage sector, a slide in business lending and a small rise in personal credit (much of the slack here is being picked up in the Alternative Lending sector which will be subject to a separate post later).

The smoothed annual trends show the slide in investment lending in January.

Compare this with last month’s equivalent data when the RBA was running adjustments between the investor and owner occupied series. They have now stopped, as we discussed recently.  Investment lending therefor dropped from ~5% to ~3% in the past year as a result of their changes. Talk about fluff in the numbers!!

Instead they report on net switching. After a spike in 2015, when the differential pricing started to appear, its been running at around $1 billion each month.

The RBA says:

All growth rates for the financial aggregates are seasonally adjusted, and adjusted for the effects of breaks in the series as recorded in the notes to the tables listed below. Data for the levels of financial aggregates are not adjusted for series breaks. Historical levels and growth rates for the financial aggregates have been revised owing to the resubmission of data by some financial intermediaries, the re-estimation of seasonal factors and the incorporation of securitisation data. The RBA credit aggregates measure credit provided by financial institutions operating domestically. They do not capture cross-border or non-intermediated lending.

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers changed the purpose of their existing loan. Adjustments for these switching flows have been applied to the growth figures over the period from mid to late 2015 when this switching was unusually large, but not thereafter, as the amount of switching each month subsequently decreased and remained relatively stable (and thus appears to reflect regular behaviour that occurs from month to month). All switching flows are reflected in the level of owner-occupier and investor credit outstanding. For more information, including on past treatment of switching flows, please see February 2018 SMP – Box D: Measures of Investor and Owner-Occupier Housing Credit.

Comparing the APRA and RBA data, it appears the non-bank lending sector is still enjoying significant growth.

Why More Lending Curbs Are Still Likely

There is a rising chorus demanding that APRA loosen their rules for mortgage lending in the face of slipping home prices. This despite the RBA’s recent comments about the risks in the system, especially relating to investor and interest only loans.  But this is unlikely, and in fact more tightening, either by a rate rise, or macroprudential will be needed to contain the risks in the system. The latter is more likely.

Some of this will come from the lenders directly. For example, last week ANZ said it will be regarding all interest-only loan renewals as credit critical event requiring full income verification from 5 March. If loans failed this assessment these loans would revert to P&I loans (with of course higher repayment terms).  We are already seeing a number of forced switches, or forced sales thanks to the tighter IO rules more generally. This is just the start. More than $60 billion of IO loans are outside current underwriting standards on our estimates.

But, as ANZ has pointed out in a separate note from David Plank, Head of Australian Economics at ANZ; household leverage is still increasing, this despite a moderation in housing credit growth over the past year. Household debt continues to grow faster than disposable income.

With household debt being close to double disposable income it will actually require the growth in household debt to slow well below that of income in order for the ratio of household debt to income to stabilise, let alone fall.

In fact, he questions whether financial stability has really being improved so far, when interest rates are so very low.

A key concern we have with the RBA’s comfort with recent household debt trends is whether the slowdown in household debt growth is likely to be sustained with interest rates so low.

Our analysis on the debt/income gap suggests that the RBA’s comfort with how things are evolving on the debt front may be misplaced.

The first sign of this will be clear evidence of recovery in house prices, possibly already underway, which will likely be followed by a reacceleration in debt growth.

If things develop in this fashion it will be interesting to see whether the RBA maintains its focus on clear progress toward the mid-point of the inflation target range as the key to the setting of interest rates.

We suspect that the first port of call to any signs of a reacceleration in household debt will be additional macro-prudential policy…

In other words expect more tightening before the cash rate goes up.