Category: Financial Markets

That’s Not A Fall; THIS Is A Fall – The Property Imperative Weekly – 9th June 2018

Welcome to the Property Imperative weekly to 9th June 2018, our digest of the latest finance and property news with a distinctively Australian flavour.

Watch the video, listen to the podcast, or read the transcript.

Today, a story. In the great city of Ghor, all the inhabitants were blind. A king and his entourage arrived nearby. He brought his army and camped in the desert. He had a mighty elephant, which he used to increase the people’s awe. The populace became anxious to see the elephant, and some sightless from among the blind community ran like fools to find it. As they did not even know the form or shape of the elephant, they groped sightlessly gathering information by touching some part of it. Each thought that he knew something, because he could feel a part… The man whose hand had reached the ear of the elephant, said “It is a large, rough thing, wide and abroad, like a rug.” And the one who had felt the trunk said: “I have the real facts about it. It is like a straight and hollow pipe, awful and destructive.” The one who had felt its feet and legs said” it is mighty and firm, like a pillar.” Each had felt one part of many. Each had perceived it wrongly…

The parable of the three blind men and the elephant makes the point that depending on where you feel, or look, you get a very different view of what’s currently going on, and so too with the economy.

For example, superficially, the latest GDP numbers released this week by the ABS were good news, showing 1.0% growth in real GDP over the quarter and a 3.1% rise over the year. The Treasurer was effusive. But below the spin, things are not so clear cut. In fact, net exports drove most of the growth because the terms-of-trade which measures the prices received for Australia’s exports relative to the prices paid for imports rose by 3.3% over the quarter in seasonally adjusted terms and by 1.6% in trend terms. However, over the year it fell by 2.6% seasonally adjusted and by 0.7% in trend terms. And these movement could be one offs. We were fortunate. Quarterly final demand, which excludes export volumes, rose by 0.6% over the March quarter, driven largely by VIC (+1.9%) and NSW (+0.7%).

But, on a more relevant per capita basis, real GDP rose by just 0.7% over the quarter and was up by 1.5% over the year and real national disposable income per capita also rose by 1.5% over the quarter and was up 0.9% over the year. And most importantly for Australian workers, average compensation per employee rose by just 1.6% in the year to March, and remained negative by 0.3% after adjusting for inflation (1.9%). It was 0.4% in the quarter.  Plus, the household savings ratio continued to fall, down another 0.2% to 2.1% – the lowest reading in the post-GFC era. And what consumption there was went to necessities like electricity and fuel.

So my take is that while there is a glow of headline growth above 3%, in truth, its mainly migration led, plus a convenient shift in export prices, and a rise in government investment. Private sector business investment is sluggish, and households continue to reel from low wages growth and rising costs as signalled by falling savings, and a rise in debt.  Not such a good story then.

This is confirmed by the retail turnover figures, also out this week. The ABS data, rose 0.3 per cent in April 2018 following a similar rise the previous month. Compared to April 2017 the trend estimate rose 2.6 per cent, above income growth. Across the categories, food retailing was up 0.4%, household good up 4%, other retailing 0.2%, Cafes and takeaway food 0.1%, department stores down 0.1%, clothes and footwear down 0.2%. Across the states, the trends were strongest in NT up 0.7%, ACT up 0.6%, NSW and VIC up 0.4%, TAS up 0.2%, QLD 0.1% and SA fell 0.1%.

Elsewhere on the elephant, we reported that Mortgage Stress Notched Up Again in May 2018. You can watch our Video “Mortgage Stress Updated – May 2018”  where we discuss the details and walk though to top 10 most stressed postcodes across the country. Across Australia, more than 966,000 households are estimated to be now in mortgage stress (last month 963,000). This equates to 30.2% of owner occupied borrowing households. In addition, more than 22,600 of these are in severe stress, up 1,000 from last month. We estimate that more than 56,700 households risk 30-day default in the next 12 months. We expect bank portfolio losses to be around 2.7 basis points, though losses in WA are higher at 5 basis points.  We continue to see the impact of flat wages growth, rising living costs and higher real mortgage rates.

The post code with the highest count of stressed households, was NSW post code 2170, the area around Liverpool, Warwick Farm and Chipping Norton, which is around 27 kilometres west of Sydney. There are around 27,000 families in the area, with an average age of 34. There are 6,974 households in mortgage stress here. The average home price is $805,000 compared with $385,000 in 2010. 64% of properties are standalone houses, while 22% are flats or apartments. The average income here is $5,950. 36% have a mortgage, which is above the NSW average of 32% and the average repayment is about $2,000 each month, so the average proportion of income paid on the mortgage is more than 33%.

The RBA left the cash rate on hold again this week, no surprise, of course. But the pressure on rates are on the rise due to the rising borrowing costs in the USA, and as reflected in the bond markets, and the local BBSW.  Credit Suisse did a good job of dissecting the problem and they estimate that banks have something like a 0.5% – or 50 basis point gap in funding thanks to the changes in the rates. We discussed this in our video  So, How Much Pressure on Bank Margins Now and look the RBA’s recent outing where they sought to explain away the pressure on rates. But Credit Suisse concludes:

The key issue is that the pipeline of out of cycle rate hikes is growing, with no end in sight until the RBA resolves the pricing mystery in the interbank market. There is too much pipeline pressure for adjustment to be borne by just one lever of credit creation, because interbank spreads are so persistently, and mysteriously wide. But recent commentary and the lack of responsiveness of interbank spreads to liquidity injections suggests to us that the Bank is no closer to resolving the mystery than it was in April, when it first noted tightening. The sheer depth of the pipeline of out of cycle rate hikes due to elevated funding pressures is beyond what policy makers are currently envisaging. To be sure, Banks do not have to hike rates out of cycle, or limit pass through of potential RBA rate cuts to end borrowers. They could cut deposit rates. Or they could take a hit to profitability, effectively passing on the funding pressure to shareholders rather than borrowers. But interestingly: 1.    RBA work suggests that there are non-linearities in pass through when cash rates fall, precisely because deposit rates are already so low. As the cash rate falls, the relative cost of low/no interest fixed deposits increases. Substitution out of higher yielding deposits into low/no interest fixed deposits offsets this increase in relative cost – but there is a limit to the offset once the cash rate falls too far. 2.    If margins take a hit, or are likely to take a hit, potentially banks could tighten lending standards even more aggressively than they currently are doing. Interestingly, interbank credit spreads currently point to a much sharper fall in loan approvals than our proprietary credit conditions index, based on publicly available data on bank lending standards. In other words, the growth shock from incremental credit tightening may be just as bad, if not worse, than out of cycle rate hikes, or lack of pass through. The issue is that corporate credit spreads are unusually low in comparison with interbank credit spreads.

And UBS discussed whether banks are likely to be able to pull out from their current market price falls. Australian banks they say…

have now underperformed the Australian market on a rolling 3-year timeframe and the sectors PE discount to market ex-resources has widened to the most since 2008. They rightly argue that bank profitability and share market performance is all about credit growth, and indeed the high growth in loans helped offset the fall in interest rates in the past couple of years.  They conclude “UBS’s work on the prospect of a tightening credit cycle (see Credit Crunch? Seven factors to consider) suggests the ability to rebound from the current earnings lull will be very difficult, even if one subscribes to a “soft landing” scenario for house prices, credit growth and the economy. Credit growth should at a minimum grind lower over coming years. Bank NIMs are likely to be under at least moderate pressure (given BBSW trends) while bad debts at absolute best will be a neutral influence. The muted earnings outlook suggests that one can subscribe to a soft landing for housing and the economy amid tighter credit but still adhere to a strategic underweight in the sector. Of course a sharper credit slowdown will compound the headwinds for the sector.

And the fact is, so far the RBA has never started a tightening cycle at a time when dwelling prices are declining, until now.

So we hold to our view that mortgage rate pressure is on, and that will put more pressure on home prices which continue to fall.  The bellwether is of course the auction clearance rates, which CoreLogic reported as now hitting a final weighted average last week of 46.91%. The signs are clear as we head into winter that fewer properties are being sold, more are being passed in and the number for sale, is growing by the day.  SQM Research said this week

We continue to see a shortage of properties available for sale in Hobart. But elsewhere, the story is different, with greater supply now evident in most capitals compared to a year ago, leading to slowing growth in property asking prices as supply increases. We are also seeing more property being listed in Melbourne compared to a year ago, which has taken pressure off asking property prices for houses and units, which fell over the month. Even in Hobart, price growth has slowed despite the ongoing shortage of properties for sale there.

Corelogic’s Index shows that in Sydney, values fell by 0.11% last week and average values have fallen declined by 4.8% over the past 39-weeks. But this is an average, and some more expensive properties are more than 15% down now from their peaks.  Auction clearances in Sydney’s mortgage belt – which runs in a ring from the southern beaches though Canterbury-Bankstown, Parramatta and the North West – have collapsed deep into the 30%s.

Melbourne fell by another 0.07%, and dwelling values have now also declined by 1.7% over the past 27 weeks, but is still positive by 1.9% over the past year. Two points to make here, first again the top of the market is moving sharply lower, and second, we think Melbourne is 6 to 9 months behind the Sydney trajectory, but is firming in the same direction. We are in correction territory now, and falls will accelerate.  And frankly as Sydney and Melbourne contain the bulk of the population and property, what happens in these two states will set the tone elsewhere.

This week we heard about criminal proceedings against CBA relating to the AUSTRAC sage, which, subject to count approval will be settled at $700m plus costs. A big number perhaps, but much smaller than might have been the case and hardly enough to be a real deterrent.  We discussed this in our separate video and podcasts “What The CBA AUSTRAC Settlement Means”.

And the ACCC is going after ANZ, plus Deutsche Bank and CitiGroup’s investment banking arms alleging they engaged in cartel-like behaviour relating to a share placement in 2015.  We discussed this in our post “Now Investment Banking Is Under The Microscope”, available on YouTube or via Podcast.

And talking of YouTube, we ran our first livestreaming Q&A session last Tuesday, with a couple of hundred people joining in. You can watch the 1:20 programme on replay on YouTube including the live chat, or listen to the podcast version. Thanks to everyone who joined in, and for those who sent questions in advance. I have to admit, we did not cover them all, so I will plan an extra offline session to answer some of the outstanding questions in the next few days. We will plan another live Q&A session in a couple of months, so watch out for that too.

Before we finish, a quick scan of the global financial markets – as I have received feedback that this part of the weekly reviews are well received.

First then, U.S. stock markets rose more than 1% this week but gains were held back in the latter part of the week somewhat as focus shifted to escalating trade tension between the U.S. and its key allies as the G7 summit got underway. U.S. President Trump refused to back down from his tough stance on tariffs, as he vowed to “fight” for the United States, and criticised allies, accusing them of imposing massive tariffs and creating non-monetary barriers. Tech was also one the stories of the week after coming under pressure on Thursday and Friday as Facebook and Apple fell. Apple fell nearly 1% Friday on reports the iPhone maker warned its supply chain to make fewer parts for iPhones in the second half of 2018 amid expectations for lower sales. Shares of Tesla rallied sharply this week after CEO Elon Musk said it is “quite likely” Tesla will hit a weekly Model 3 production rate of 5,000 cars by the end of June. The S&P 500 closed more than 1% higher for the week at 2,779.03.

Crude oil prices posted a third straight weekly loss after settling lower Friday on concerns about ongoing U.S. output after data showed the number of U.S. oil rigs continued to climb. Oil price action was choppy for most of the week as OPEC members attempted to allay fears the oil cartel would lift limits on production curbs at its June 22 meeting. U.S. oil output, meanwhile, continued to rise as the Energy Information Administration said Wednesday U.S. oil output rose to a record 10.8 million barrels per day. Oil prices were also limited by a weekly Energy Information Administration report showing U.S. crude supplies unexpectedly rose by 2.072 million barrels in the week ended June 1. Crude futures settled 22 cents lower on Friday as data showed U.S. oil rigs continued to climb, pointing to signs of growing domestic output.

The US dollar posted its first weekly loss in four weeks despite expectations the Federal Reserve will hike rates next week for the second time this year. 33.8% of traders expect the FED to hike rates for a fourth time at its December meeting, up from under 30% last week. The Federal Reserve will also release its summary of economic projections outlining expectations for key measures of the U.S. economy including inflation, interest rates, unemployment and GDP. The dollar was held back by a resurgent euro as European Central Bank policymakers stoked expectations the ECB would tighten monetary policy sooner rather than later. The dollar rose 0.12% to 93.54 against a basket of major currencies on Friday.

Locally, the Aussie Dollar held at 76 cents to the US dollar.

Gold prices bounced back from a weekly slump as dollar weakness encouraged buying, which was tentative, however, with a widely expected Fed rate hike on the horizon. Gold prices were unable to capitalise on rising geopolitical tensions as U.S. President Donald Trump went into the G7 meeting expecting a frosty reception after lashing out at Canada and the European Union. Gold appeared to be in ‘wait-and-see’ mode through the week as trading was restricted to a narrow range ahead of the Fed rate decision and the release of the central bank’s economic estimates.

Bitcoin seesawed its way to end the week roughly unchanged as regulatory uncertainty continued to weigh on sentiment despite signs of increasing institutional demand for the popular cryptocurrency. A report this week that Wall Street giant Fidelity was eyeing a move into the crypto space, planning to create products that would push the market for bitcoin to the “next level,” attracted a muted reaction. Bitcoin rose to a high of $7,777.4, testing a price level which some have identified as resistance – price levels that trigger selling – before paring gains. On the regulatory front, SEC chief Jay Clayton said this week, bitcoin was not a security, and further clarified the U.S. financial watchdog’s position on initial coin offerings, or ICOs. Demand for cryptocurrencies modestly improved as data showed the total crypto market cap rose to about $342 billion, at the time of writing, from about $329 billion a week ago.

And so back to the elephant analogy. There are a number of lumps and bumps across the US economy which suggests that pressure is building. For example, the flatter US yield curve underscores the lift in short term rates, and there is more to come. Higher rates mean that individuals and corporations will have to pay more. This chart shows the growth in US personal debt and the fall in savings, a trend which have grown in the past decades. Debt has never been higher, and savings is through the floor.

And remember that the US Government will have to pay more for their debt. This is important because the US Government is financing almost 25% of US GDP, and you have to ask whether this is sustainable.

But we still expect US rates to move higher, putting more pressure on local rates here. And there are simply no signs yet of any improvement in wages, as costs go on rising. Meantime the tighter lending controls and lack of sales momentum will see prices fall further, and by the way ANZ was the latest to forecast bigger falls, so more are joining the chorus – but the question is still extent and timing. Our modelling suggests we will see more severe falls, and we will be discussing this in upcoming posts

But the bottom line is compared with what we have seen so far, more falls must be expected, with all the downstream consequences which follow.

Are We Facing Another Financial Sector Crisis?

At first blush the news at home and abroad appears to be steering us towards our most risky – scenario 4 outcome, where global financial markets are disrupted and home prices fall by 20-40 percent or more as confidence wains.

Some would call this GFC 2.0. So let’s looks at the evidence.

In Australia, as we predicted, a massive class action lawsuit is being planned on behalf of “Australian bank customers that have entered into mortgage finance agreements with banks since 2012”.

Law firm Chamberlains has been appointed to act in the planned class action lawsuit, which has been instructed by Roger Donald Brown of MortgageDeception.com in the action that aims to represent various Australian bank customers that are “incurring financial losses as a result of entering into mortgage loan contracts with banks since 2012”.

As the AFR put it – Lawyers’ representing up to 300,000 litigants are planning an $80 billion action against mortgage lenders, mortgage brokers and financial regulators in a class action that would dwarf previous actions. Roger Brown, a former Lloyds of London insurance broker, said he already has about 200,000 borrowers ready to join the action and has $75 million backing from UK and European investors. There has been a scam, he said about mortgage lending to Australian property buyers. “But the train has hit the buffers and there needs to be recompense.

As we discussed before, if loans made were “unsuitable” as defined by the credit legislation, there is potential recourse. This could be a significant risk to the major players if it gains momentum.  And more will likely join up if home prices fall further and mortgage repayments get more difficult. But we think individuals must take some responsibility too!

Next, we now see a number of the major media outlets starting to blame the Royal Commission for the falls in home prices, tighter lending standards and even damage to the broader economy. Talk about shoot the messenger. The fact is we have had years of poor lending practice, and poor regulation. But the industry and regulators kept stumn preferring to enjoy the fruits of over generous lending. The Royal Commission is doing a great job of exposing what has been going on. In fact, the reaction appears to be that what had been hidden is now in the sunshine, and it is true the sunlight is the best disinfectant.  Structural malpractice is being exposed, some of which may be illegal, and some of which certainly falls below community expectations. But let’s be clear, it’s the poor behaviour of the banks and the regulators which have placed us in this difficult position. Hoping bad lending remans hidden is a crazy path to resolution. At least if the issues are in the open they stand a chance of being addressed.

But it is also true that just a lax lending allowed households to get bigger mortgages than they should, and bid home prices higher, to be benefit of the banks, and the GDP out-turn, the reverse is also true. Tighter lending will lead to less credit being available, which in turn will translate to lower home prices, and less book growth for the banks. But do not lay this at the door of the Royal Commission. They are actually doing Australia a great service, in a most professional manner.

But that does not stop the rot. UBS came out today with an update saying that the housing market is slowing, with house prices falling and credit conditions tightening. Given the number of headwinds the market is facing; many investors are now questioning whether the housing correction could become disorderly. We expect credit growth to slow sharply and believe the risk of a Credit Crunch is rising.

They walk through the main areas, including tighter lending, interest only loans and foreign buyers. Specifically, they highlight that approved foreign investment in housing is down -65%. The Foreign Investment Review Board just released data for 16/17. The value of approvals to buy residential housing collapsed 65% y/y to $25bn in 16/17, the lowest level since 12/13, and mostly reversing the prior ‘super boom’. The fall was across both new (-66% to $22bn) and established housing (-59% to $3bn) – led by total falls in NSW (-66% to $7bn) and Victoria (-61% to $11bn.

They say that the collapse in 16/17 may be overstated because of the introduction of application fees in Dec-15 – meaning the fall in transactions is less pronounced. But, there is still likely to have been a drop in transactions, reflecting more structural factors including – the lift in taxes on foreigners; domestic lenders tightening standards for foreign buyers (effectively no longer lending against foreign sources of income or collateral); as well as tighter capital controls especially from China.

Their base case is for a small fall in prices ahead, and assumes house prices fall by 5%+ over the coming year and that bad and doubtful debts increase only modestly given the current very benign credit environment. but they also talk about a downside scenario which reflects a more disorderly correction in the housing market (ie a Credit Crunch) and could result in approximately 40% reduction in major bank share prices. This is likely due to credit growth falling more substantially, by ~2-3% compound and credit impairment charges rising significantly as the credit cycle turns. This scenario would put pressure on bank NIMs. Litigation risk from class actions for mortgage misselling is also a tail risk. Dividends would need to be cut in this scenario. Given the leverage in the banking system, accurately predicting the extent of a downturn is very difficult, as was seen in 2008.

And the reason they still hold to their milder view is the expectation that the Government will step in to assist, and slow the implementation of recommendations from the Royal Commission.  To quote Scott Morrison on 2GB radio on 23d March.

If banks stop lending, then what do people think that is going to mean for people starting businesses or getting loans or getting jobs or all of this. In the budget papers, the Treasury have actually highlighted this as a bit of a risk with the process we are going through. We have got to be very careful. These stories are heartbreaking, I agree, but we have to be also very cautious about, well, how do we respond to that. What is the right reaction to that? Is it to just throw more regulation there which basically constipates the banking and financial industry which means that people can’t start businesses and people can’t get jobs, people can’t get home loans. Or do we want to move to a smarter way of how this is all done and I think in the era of financial technology in particular there are some real opportunities there. We are going to continue to listen and carefully respect the royal commission, not prejudge the findings, but be very careful about any responses that are made because this can determine how strong an economy we live in over the next ten years and whether people get jobs and start businesses.

But in essence, expect some unnatural acts from the Government to try to keep the bubble going a little longer. All bets are off the other side of the election.

And the third risk, and the one which takes us closest to GFC 2.0 is what is happening in Italy. I am not going to go back over the history, but after months of wrangling, Italy’s political crisis has a hit an impasse, with new elections now increasingly likely. The country faces an institutional crisis without precedent in the history of the Italian republic. Its implications extend well beyond Italy, to the European Union as a whole.

Since an election on March 4, there have been endless vain attempts to form a government – with the likely outcome changing every 24 hours. By mid-May, the Five Star Movement (M5S) and the League, both populist parties, had come together to draft a programme for government featuring tax cuts and spending plans. But it sent shivers down the spines of those contemplating Italy’s public debt – running at over 130% of GDP – and threatened the stability of the eurozone.

The appointment of Carlo Cottarelli, a former official from the International Monetary Fund, as prime minister on May 28 was merely a stop-gap measure until fresh elections in the autumn. His government will almost certainly fail to win the necessary vote of confidence required of all incoming governments upon taking office. This means that it will be unable to undertake any legislative initiatives that go beyond day-to-day administration.

ITALY’S president, Sergio Mattarella had originally planned to put a former IMF economist, Carlo Cottarelli, at the head of a government of technocrats, tasked with steering the country back to the polls after the summer. But Mr Mattarella was reportedly considering changing tack after meeting Mr Cottarelli on May 29th amid growing evidence of support in parliament for an earlier vote. Not a single big party has declared its readiness to back Mr Cottarelli’s proposed administration in a necessary vote of confidence.

So the president is expected to decide on May 30th whether to call a snap election as early as July in an effort to resolve a rapidly deepening political and economic crisis that has sent tremors through global financial markets.  There was also concern that the populist parties could win a bigger parliamentary majority in the new election, creating a bigger risk for the future of the eurozone.

In a sign of investors’ concern, the yield gap between Italian and German benchmark government bonds soared from 190 basis points on May 28th to more than 300. The governor of the Bank of Italy, Ignazio Visco, warned his compatriots not to “forget that we are only ever a few steps away from the very serious risk of losing the irreplaceable asset of trust.”

The yield on two-year debt has risen from below zero to close to 2% and Italy’s 10-year bond yields, which is a measure of the country’s sovereign borrowing costs, breached 3 per cent on Tuesday, the highest in four years. At the start of the month they were just 1.8 per cent. Italy’s sovereign debt pile of €2.3 trillion is the largest in the eurozone

The Italian stock market was also down 3 per cent on Tuesday, and has lost around 13 per cent of its value this month.

But these movements need to be put in some context. The Italian stock market is still only back to its levels of last July, after experiencing a strong bull run since later 2016.

In 2011 and 2012 Italian bond breached 7 per cent and threatened a fiscal crisis for the government in Rome. Yields are still some distance from those extreme distress levels.

George Soros was quoted in the FT:

The EU is in an existential crisis. Everything that could go wrong has gone wrong,” he said. To escape the crisis, “it needs to reinvent itself.”  Mr Soros said tackling the European migration crisis “may be the best place to start,” but stressed the importance of not forcing European countries to accept set quotas of refugees. He said the Dublin regulation — which decides which nation is responsible for processing a refugee’s asylum status, largely based on which country the individual first enters — had put an “unfair burden” on Italy and other Mediterranean countries, “with disastrous political implications.”  While austerity policies appeared initially to have been working, said Mr Soros, the “addiction to austerity” had harmed the euro and was now worsening the European crisis. US president Donald Trump’s exit from the nuclear arms deal with Iran and the uncertainty over tariffs that threaten transatlantic trade will harm European economies, particularly Germany’s, he said, while a strong dollar was prompting “flight” from emerging market economies.     “We may be heading for another major financial crisis,” he said.     Meanwhile, years of austerity policies had led working people to feel “excluded and ignored,” sentiment that had been exploited by populist and nationalistic politicians, said Mr Soros. He called for greater emphasis on grassroots organisations to meaningfully engage with citizens.

To play devil’s advocate, if Italy were to leave the Eurozone, the Lira would drop, hard.  Most probably Italy would default on debt, and this would hit the Eurozone banks hard, especially those in     German and French banks will be hit hard and they are saddled with about half the outstanding debt. Just like in the GFC a decade back, global counter-party bank risk will rise, and this time sovereign are involved, so it may go higher. The US Dollar will run hot, and there will be a flight to quality, tightening the capital markets, lifting rates and causing global stocks and commodities to crash, possibly a recession will follow.

In Australia, the dollar would slide significantly, fuelling stock market falls and a further drop in home prices, leading to higher levels of default, and recession, despite the Reserve Bank cutting rates and even trying QE.

Now the financial situation in Italy at the moment, a far cry from the height of the eurozone crisis in 2012, when it really did look possible that weaker member states would be imminently forced to default and the single currency would collapse. Then, that situation was finally defused when the head of the European Central Bank, Mario Draghi, announced he would do “whatever it takes” to stop this break up happening, unveiling an emergency programme of backstop bond buying by the central bank. This reassured private investor that they would, at least, get their money back and bond yields in countries like Italy and Spain fell back to earth, ending the risk of a destructive debt spiral.

But the latest deadlock in Rome is nevertheless the biggest crisis in the eurozone since Greece last threatened to leave in 2015. And Italy is a much larger economy than Greece. If the third largest country in the bloc exited the euro, it is doubtful the single currency would survive.

Falling bank shares dragged down Europe’s main share markets. At the close the UK’s FTSE 100 fell almost 1.3%, while Germany’s Dax was down 1.5% and France’s Cac 1.3% lower. “It’s a market that is totally in panic”, said a fund manager at Anthilia Capital Partners, who noted “a total lack of confidence in the outlook for Italian public finances”. And the chief economic adviser at Allianz in the US said: “If the political situation in Italy worsens, the longer-term spill overs would be felt in the US via a stronger dollar and lower European growth.”

So whether you look locally or globally its risk on at the moment, and we are it seems to me teetering on the edge of our Scenario 4. This will not be pretty and it will not be quick. I see that slow moving train wreck still grinding down the tracks, with no way out.

Westpac Dodges Rate Rigging Charges

The Federal Court has determined ASIC failed to prove Westpac manipulated the bank bill swap rate, but the judge found the bank engaged in unconscionable conduct, via InvestorDaily.

Justice Beach of the Federal Court has handed down a 643-page judgement on a civil court case brought by ASIC that alleged Westpac manipulated the bank bill swap rate (BBSW).

In his judgement, Justice Beach found ASIC has “not made out its case against Westpac” concerning market manipulation or market rigging.

However, he did find that Westpac engaged in unconscionable conduct under s12CC of the ASIC Act on four occasions (6 April 2010, 20 May 2010, 1 and 6 December 2010) “by trading Prime Bank Bills in the Bank Bill Market with the dominant purpose of influencing yields and where BBSW is set”.

Westpac was also found to have contravened paragraphs 912A(1)(a), (c), (ca) and (f) of the Corporations Act, which relate to the obligations of financial services licensees to operate efficiently, honestly and fairly.

ASIC did not make out its case in respect to any of its other claims, said the judgement.

In his summary, Justice Beach said Westpac had failed to take “reasonable steps” to ensure its representatives did not engage in trading in Prime Bank Bills with the “sole or dominant purpose of manipulating the BBSW”.

“Further, in my view Westpac failed to ensure that its traders were adequately trained not to engage in trading with such a sole or dominant purpose,” said the judgement.

“This should have been reinforced and stipulated to them orally and in writing. In those circumstances, Westpac also contravened s 912A(1)(f).”

Federal Court finds Westpac traded to affect the BBSW and engaged in unconscionable conduct

ASIC says Justice Beach of the Federal Court today found that Westpac engaged in unconscionable conduct under s12CC of the Australian Securities and Investments Commission Act 2001 (Cth) by its involvement in setting the bank bill swap reference rate (BBSW) on 4 occasions.

In civil proceedings brought by ASIC, the Court found that on these occasions, Westpac traded with the dominant purpose of influencing yields of traded Prime Bank Bills and where BBSW set in a way that was favourable to its rate set exposure.

The court also found Westpac had inadequate procedures and training and had contravened its financial services licensee obligations under s912A(1)(a), (c), (ca) and (f) of the Corporations Act 2001 (Cth)

His Honour said in his judgement, “Westpac’s conduct was against commercial conscience as informed by the normative standards and their implicit values enshrined in the text, context and purpose of the ASIC Act specifically and the Corporations Act generally.”

A further hearing of this proceeding on penalty and relief will be held on a date to be determined.

Background

ASIC commenced legal proceedings in the Federal Court against the Australia and New Zealand Banking Group (ANZ) on 4 March 2016 (refer: 16-060MR) and against National Australia Bank (NAB) on 7 June 2016 (refer: 16-183MR).

On 10 November 2017, the Federal Court made declarations that each of ANZ and NAB had attempted to engage in unconscionable conduct in attempting to seek to change where the BBSW was set on certain dates and that each bank failed to do all things necessary to ensure that they provided financial services honestly and fairly. The Federal Court imposed pecuniary penalties of $10 million on each bank (refer: [2017] FCA 1338).

On 20 November 2017, ASIC accepted enforceable undertakings from ANZ and NAB which provides for both banks to take certain steps and to pay $20 million to be applied to the benefit of the community, and that each will pay $20 million towards ASIC’s investigation and other costs (refer: 17-393MR).

On 30 January 2018, ASIC commenced legal proceedings in the Federal Court against the Commonwealth Bank of Australia (CBA) (refer: 18-024MR).

On 8 May 2018, CBA announced that ASIC and CBA reached an in-principle agreement to settle ASIC’s claims (refer: CBA ASX Announcement). CBA and ASIC will be making an application to the Federal Court for approval of the settlement.

ASIC has previously accepted enforceable undertakings relating to BBSW from UBS-AG, BNP Paribas and the Royal Bank of Scotland (refer: 13-366MR, 14-014MR, 14-169MR). The institutions also made voluntary contributions totaling $3.6 million to fund independent financial literacy projects in Australia.

In July 2015, ASIC published Report 440, which addresses the potential manipulation of financial benchmarks and related conduct issues.

On 28 March 2018, Parliament passed legislation to implement financial benchmark regulatory reform.

On 21 May 2018, the new BBSW calculation methodology commenced, calculating directly from market transactions during a longer rate-set window and involving a larger number of participants. This means that the benchmark is anchored to real transactions at traded prices (refer: 18-144MR).

ASIC and RBA welcome the new BBSW calculation methodology

ASIC and the Reserve Bank of Australia (RBA) have welcomed the new BBSW calculation methodology, which commenced today.

The bank bill swap rate (BBSW) rate is a major interest rate benchmark for the Australian dollar and is widely referenced in many financial contracts. Previously, BBSW was calculated from the best executable bids and offers for Prime Bank securities. A major concern over recent years has been the low trading volumes during the rate-set window, the period over which the BBSW is measured.

The new BBSW methodology calculates the benchmark directly from market transactions during a longer rate-set window and involves a larger number of participants. This means that the benchmark is anchored to real transactions at traded prices. ASX, the administrator of BBSW, has consulted market participants on this new methodology. In addition, the ASX has recently conducted a successful parallel run of the new methodology against the existing method.

RBA Deputy Governor Guy Debelle said, ‘The new methodology strengthens BBSW by anchoring the benchmark to a greater number of transactions. This should help to ensure that BBSW remains robust.’

ASIC Commissioner Cathie Armour said, ‘A transaction-based BBSW supports the market’s trust in the robustness and reliability of BBSW.’

‘ASIC and the RBA expect all bank bill market participants – including the banks that issue the bank bills, as well as the participants that buy them – to adhere to the ASX BBSW Guidelines and support the new BBSW methodology. The rate-set window is the most liquid period in the bank bills market, and market participants are therefore likely to get the best outcomes for their institutions and their clients by trading during this time.’

‘We expect market participants to put in place procedures so that as much trading as possible happens during the rate-set window.

This change follows passage through the Parliament in March of legislation that puts in place a framework for licensing benchmark administrators. Consistent with the approach taken in a number of other jurisdictions, it also made manipulation of any financial benchmark, or products used to determine such a benchmark, a specific offence and subject to civil and criminal penalties.

ASIC intends shortly to make financial benchmark rules, on which ASIC consulted in 2017. ASIC also expects to declare BBSW, and a number of other financial benchmarks, as ‘significant benchmarks’ in Australia and to license the administrators of those significant benchmarks.

Equity markets a ‘house of cards’: FIIG

With US 10-year bond yields at a seven-year high, a relatively minor shock could be enough to trigger forced selling on equity markets, says FIIG via InvestorDaily.

The yield on 10-year US treasuries closed at 3.11 per cent overnight on Friday, a seven-year high that prompted speculation about a shift out of equities.

Speaking to InvestorDaily, FIIG NSW state manager Jon Sheridan said that if the 10-year holds at this level it will have broken the long-term secular downtrend in yields.

While he did not profess to be a “massive believer” in technical analysis, he said it is important to realise that many of the people trading in markets do.

And with high levels of margin debt and stretched valuations on the S&P 500 index, equity markets are looking like a “bit of a house of cards at the moment”, Mr Sheridan said.

“A strong gust, whatever that might be – it might be a geopolitical thing, or Facebook getting regulated, or Tesla raising capital – could break the fragile confidence,” he said.

“And then it all comes tumbling down and then you’ve got algorithmic selling, and margin debt being called and forced selling – all the waterfall effects that you don’t want to see if you’re an equity investor.”

There are three indicators that have Mr Sheridan worried about the future trajectory of the current US equity bull run.

First, the three-month US treasury bill is now above the yield on the S&P 500. In other words, he said, investors can get a higher (and risk-free) yield on three-month treasuries than they can get from the dividend yield of the stocks on the S&P 500.

Second, the 10-year treasury yield, at 3.11 per cent, is above the terminal US Federal Reserve funds rate of 2.75-3 per cent – something that has never happened before (at least “sustainably”).

“What that means is that if you think history will play out again, you should actually be a buyer of longer-dated bonds, because the chances are that yields aren’t going any higher from here. And in fact may even go lower,” Mr Sheridan said.

Finally, the spread between the US 10-year and 2-year yields has fallen to 51 basis points (down from 1 per cent a year ago, and from 2.62 per cent in December 2013).

When the spread goes negative (i.e, ‘inverts’) it means 2-year yields are higher than their 10-year counterparts.

“Every time since World War Two there has been a recession within 1 to 3 years from that inversion,” Mr Sheridan said.

“That’s the main signalling influence that the yield curve has in terms of the general economic outlook, and of course recession is terrible for stocks and property, because they’re risk-on assets,” he said.

More Data On The Downside – The Property Imperative Weekly 19th May 2018

Welcome to our latest summary of finance and property news to the 19th May 2018.

Watch the video or read the transcript.

Today we start with bank culture and the next round of the Royal Commission.New ASIC chairman James Shipton was at the Australian Council of Superannuation Investors conference in Sydney and was asked how seriously he was taking the threat to the financial system given the failures aired at the royal commission. He said the threat is great. As a former member of the finance profession – as a person who is proud to be a financier – I find it jarring and disappointing that this is where we find ourselves,” he said. As a proud Australian who is returning from nearly 25 years overseas, it is very confronting that we find ourselves in this situation. The misconduct discussed at the royal commission “must not stand, [it] must be addressed”

Mr Shipton also highlighted the “proliferation” of conflicts of interest in parts of the financial industry. “It is clear to me that a number of institutions have not taken the management of conflicts of interest to heart,” he said. “This is verging on a systemic issue. Indeed, it is the source of much of the misconduct ASIC has been responding to and which is being highlighted by the royal commission hearings.” Mr Shipton expressed his “surprise” that many Australian firms have “turned a blind eye” to conflicts of interest as their businesses have grown. “Too often, unacceptable conflicts were justified by firms on the basis that ‘everyone else is doing it’, even though it’s the right thing to do to end them .“A business culture that is blind to conflicts of interest is a business culture that does not have the best interests of its customer in mind. Moreover, it is one that is not observing the spirit as well as the letter of the law,” he said.

These are relevant comments in the light of the next round of the Royal Commission which starts on 21st May. This round of public hearings will consider the conduct of financial services entities and their dealings with small and medium enterprises, in particular in providing credit to businesses. The hearings will also explore the current legal and regulatory regimes, as well as self-regulation under the Code of Banking Practice.  They will use the same case study approach.

They will be considering Responsible lending to small businesses, with ANZ, Bank of Queensland,  CBA, Westpac and Suncorp on the stand. They will then consider the Approach of banks to enforcement, management and monitoring of loans to businesses with CBA / Bankwest and NAB. Third will be Product and account administration with CBA and Westpac; then the Extension of unfair contract terms legislation to small business contracts with ASIC and finally The Code of Banking Practice with ABA and ASIC. This should be worth watching, as we are expecting more cases of misconduct and poor behaviour.  Our Small and Medium Business surveys highlight the problem many have with getting credit and being treated unfairly. There is a link below if you want to grab a free copy.

So now to the statistics. The ABS data this week painted a rather unsettling picture. The latest unemployment data to April 2018 showed that employment growth is slowing. The trend unemployment rate rose from 5.53 per cent to 5.54 per cent in April 2018 after the March figure was revised down, while the seasonally adjusted unemployment rate increased 0.1 percentage points to 5.6 per cent.  The trend participation rate increased to a further record high of 65.7 per cent in April 2018 and in line with the increasing participation rate, employment increased by around 14,000 with part-time employment increasing by 8,000 persons and full-time employment by 6,000 persons in April 2018. But as we discussed in our separate post “Jobs Aren’t What They Use To Be” underutilisation  – or those in work who want more work, continues to running at very high rates, and this helps to explain the low wages growth, which was also reported by the ABS this week. This showed a showed a further fall compared with last time with the seasonally adjusted Wage Price Index up 0.5 per cent in March quarter and 2.1 per cent through the year. Seasonally adjusted, private sector wages rose 1.9 per cent and public sector wages grew 2.3 per cent through the year to March quarter.

We discussed this in our post “Some Disturbing Trends”. In fact, you can mount an argument the federal budget is already shot as a result. The gap is large, and growing. And for comparison, the Average Compensation of Employees from the national accounts which is to December 2017 is tracking even lower circa 1.3%.  And the latest inflation figure is sitting at 1.9%.

An article in The Conversation this week by Stephen Kirchner, from the University of Sydney, argued that the RBA is making an explicit trade-off between inflation and financial stability concerns which is weighing on Australians’ wages. In the past, the RBA focused more on keeping inflation in check, the usual role of the central bank. But now the bank is playing more into concerns about financial stability risks in explaining why it is persistently undershooting the middle of its inflation target. In the wake of the global financial crisis, the federal Treasurer and Reserve Bank governor signed an updated agreement on what the bank should focus on in setting interest rates. This included a new section on financial stability. That statement made clear that financial stability was to be pursued without compromising the RBA’s traditional focus on inflation. But the latest agreement, adopted when Philip Lowe became governor of the bank in 2016, means the bank can pursue the financial stability objective even at the expense of the inflation target, at least in the short-term. He concluded that when the RBA governor and the federal treasurer renegotiate their agreement on monetary policy after the next election, the treasurer should insist on reinstating the wording of the 2010 statement that explicitly prioritised the inflation target over financial stability risks. If the RBA continues to sacrifice its inflation target on the altar of financial stability risks, inflation expectations and wages growth will continue to languish and the economy underperform its potential.

International funding costs continue to rise with the US 10 Year Treasury rising this week, as yields were boosted after a report on U.S. retail sales for April indicated that consumer spending is on track to rebound after a soft patch in the first quarter. Yields have climbing higher since the Fed said on at its May meeting that inflation is moving closer to its 2% target. The Fed raised rates in March and projected two more rate hikes this year, although many investors see three hikes as possible.There is a strong correlation between the 10-year bond yield and the quantitate tightening which is occurring – making the point again that the rate rises are directly correlated with the change in policy.

Libor, the interbank benchmark continued to rise, as we discussed in our post “The Problem with LIBOR”. And this translates to higher mortgage rates in the US, with US headlines speaking of “the highest mortgage rates in seven years.

To be clear, we watch the US markets, and especially the capital market rates. because these movements impact the cost of bank funding and the Australian banks, especially the larger ones need access to these funds to cover perhaps 30% of their mortgage books. As a result, there is pressure on mortgage rates locally, with the BBSW reflecting some of this already.

Canada is another market worth watching, because it shares a number of the same characteristics as our own. The authorities tightened mortgage underwriting standards earlier in the year, and the results are now some significant slowing of purchase volumes, and home prices.

Significantly, the lenders are discounting new loans to try to maintain mortgage underwriting volumes in the fading market, which is similar to the dynamics here, with some Australian lenders now offering discounts to property investors for the first time in a year or so.

We hold our view that credit growth will continue to slow, as underwriting standards get tightened further.  Investor lending has fallen by 16.1 per cent over the year to March, while owner-occupied lending is off by 2.2 per cent, according to the Australian Bureau of Statistics. The latest housing finance statistics show that lending to owner-occupiers fell by 1.9 per cent in March, the highest rate of decline in over two years; investor lending fell by 9 per cent over the month.

However, these figures are yet to reflect the latest round of credit tightening by the major banks, who face increased scrutiny amid damning evidence of irresponsible lending during the first round of the royal commission.

Both the major banks and the RBA expect credit growth to slow. We are now entering a “credit crunch”, which will reduce total mortgage volumes by around 10 per cent over the next year. The chances are that people will not be moving as swiftly as they had previously and not only is there lower demand now, particularly for property investors, but tighter lending criteria means that brokers will have to work a lot harder to get the information from clients and go through more hoops to get an application processed. Overall volumes will be down.

The Auction clearance rates continue lower, according to CoreLogic. Last week, a total of 2,279 auctions were held across combined capital cities, returning a final clearance rate of 58.2 per cent, the lowest clearance rate seen since late 2015. This time last year, the clearance rate was much stronger with 72.8 per cent of the 2,409 auctions returning a successful result.

Melbourne’s final clearance rate dropped to 59.8 per cent this week across 1,099 auctions making it the lowest clearance rate the city has seen since Easter 2014 (58.1 per cent).

Sydney’s final auction clearance rate fell to 57.5 per cent across 787 auctions last week, down from 63.1 per cent across 797 auctions over the previous week. Over the same week last year, 960 homes went to auction and a clearance rate of 74.5 per cent was recorded.

Across the smaller auction markets, Canberra, Perth and Tasmania saw clearance rates improve while clearance rates across Adelaide and Brisbane fell slightly. Of the non-capital city auction markets, Geelong returned the highest final clearance rate once again, with a success rate of 83.0 per cent across 50 auctions.

This week they expect to see a lower volume of auctions – 1,931, down from 2,279 last week. Melbourne is the busiest city for auctions again this week, with 948 auctions being tracked so far, down from 1,099 last week. Sydney has 637 auctions scheduled this week, down from 787 last week.

Adelaide and Perth are expecting to see a slight increase in auction volumes this week, with Adelaide tracking 102 auctions, up from 97 last week, while Perth currently has 43 auctions scheduled, up from 40 last week.

In terms of home price movements, prices are continuing to fall in all states last week, according to the CoreLogic Indices, other than Adelaide which was just a tad higher. Perth fell the most, down 0.11% followed by Sydney down 0.10%. The year to data movements, and the rolling 12-month view shows that Sydney is leading the way down. As we have said before, we think Melbourne is 6-9 months behind Sydney. But remember that the latest spate of lending tightening has yet to work though, so we expect prices to continue to fall.  Of course prices are still well above those from the previous peak, with Sydney still up 60% and Melbourne up 44%. However, Perth is down 11%, and the overall average is 37% higher.

Finally, The Australian Financial Security Authority released the personal insolvency activity statistics for the March quarter 2018. In state and territory terms, personal insolvencies reached a record quarterly high in Western Australia (1,020) and the highest level since the September quarter 2014 in New South Wales (2,372).  Total personal insolvencies in the March quarter 2018 increased slightly by 0.1% compared to the March quarter 2017. We discussed this data in more detail in our video “Some Disturbing Trends”

Given all the data we discussed today, we expect the insolvencies will continue to rise in the months ahead, as the impact of flat incomes, rising costs, and big debt continue to press home.

Cryptocurrency Derivatives to Test Clearinghouses, Banks

Centrally cleared cryptocurrency derivatives could be a real-world test of clearinghouses’ margining and default procedures, particularly if derivative notional volumes increase and cryptocurrencies exhibit heightened price volatility, says Fitch Ratings.

Although they have largely avoided direct exposure to cryptocurrencies, banks’ role as clearing members creates a secondary channel for cryptocurrency risk. This could indirectly affect banks under more extreme stress scenarios, such as if margining and clearinghouse capital contributions prove insufficient to absorb counterparty defaults.

A dramatic increase in financial institutions’ exposure to cryptocurrency derivatives could challenge clearinghouses and large financial institution clearing members in ways beyond those typically associated with the introduction of new market products. Cryptocurrencies are prone to extreme price volatility, which has been exacerbated by a nascent, unregulated underlying market with a limited price history and without generally accepted fundamental valuation principles. These factors complicate margin calculations, particularly related to short positions, for which losses cannot be capped. Inadequate margins may lead to use of clearinghouses’ collective funds to mitigate losses, thus calling upon the resources of non-defaulting clearing members, including many of the world’s largest banks and other financial institutions.

Bitcoin futures are cash-settled derivatives (i.e. without delivery of the base asset) that allow investors to assume long and short exposures to bitcoin prices without directly facing the cryptocurrency itself. In December 2017, CME Group and CBOE introduced the trading of bitcoin futures under the tickers BTC and XBT, respectively. BTC contracts are cleared through CME Clearing, while XBT contracts are cleared through Options Clearing Corporation (OCC).

As of May 9, 2018, open interests in XBT and BTC were modest at 6,287 and 2,479 contracts, respectively, worth approximately $59 million and $116 million, respectively. However, if challenges associated with trading the cryptocurrency are addressed, including uncertainty over regulatory, tax and legal frameworks, cryptocurrency derivative volumes could grow.

Clearinghouses have imposed high initial margin requirements, as well as price and position size limitations, suggesting a cautious approach thus far to trading cryptocurrency derivatives. As of May 9, 2018, initial (maintenance) margin requirements at CME were 43% of the associated notional amount, while at OCC the percentage was 44%, up from around 30% at the derivatives’ introduction in December 2017. Position limits at both exchanges are limited to 5,000 contracts in total or 1,000 in spot/expiring contracts. Consistent with price limitations for equity indexes, the maximum price limits at CME and CBOE are set at 20% above or below the previous day’s closing price, and trading is not permitted outside this band. There are also special price fluctuation limits set at 7% and 13%, which lead to temporary trading suspension.

The CME and OCC have not yet established separate legal entities or default funds for cryptocurrency derivatives, instead allocating exposure to the same default funds as equity indexes. This is understandable given the cost inefficiencies of establishing entities and default funds for what is currently a relatively low volume business. Nevertheless, a member default from losses on cryptocurrency derivatives may cause disruptions in other cleared products. Should centrally-cleared cryptocurrency derivatives materially grow, Fitch would expect clearinghouses at a minimum to establish separate default funds in an effort to isolate and mitigate associated risks.

The Problem With LIBOR

The cost of money continues to rise, and this includes the LIBOR benchmark rate, as shown by this chart. LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. As it climbs, it signals rate rises ahead.

But what is LIBOR, and more importantly, will it survive?

ICE LIBOR stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). The LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There is a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate (usually referred to as the “current LIBOR rate”), as shown in the chart.

So, LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound and is referenced in around US$350 trillion worth of contracts globally. A large share of these contracts have short durations, often three months or less. But it’s up for a shakeout as RBA Deputy Governor Guy Debelle Discussed recently.

Last year, the UK Financial Conduct Authority raised some serious questions about the sustainability of LIBOR. That is, apart from the rate fixing problems and the ensuing large fines.

The key problem is that there are not enough transactions in the short-term interbank funding market to reliably calculate the benchmark. In fact, the banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so. There is no guarantee at all that will be the case.

So market participants that use LIBOR need to work on transitioning their contracts to alternative reference rates. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems. The process is not straightforward. A large share of these contracts have short durations, so these will roll off well ahead of 2021, but they should not continue to be replaced with another short-dated contract referencing LIBOR. A very sizeable number of current contracts would extend beyond 2021, with some lasting as long as 100 years.

So regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR. These alternative rates are based on overnight funding markets since there are plenty of transactions in these markets to calculate robust benchmarks. Last month, the Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate (SOFR) as the recommended alternative to US dollar LIBOR. For the British pound, SONIA has been identified as the alternative risk-free rate, and the Bank of England has recently put in place reforms to ensure that it remains a robust benchmark.

But these chosen risk-free rates are overnight rates, while the LIBOR benchmarks are term rates. Some market participants would prefer for the LIBOR replacements to also be term rates. While the development of term risk-free rates is on the long-term agenda for some currencies, they are unlikely to be available anytime soon. This reflects that there are currently not enough transactions in markets for term risk-free rates – such as overnight indexed swaps (OIS) – to support robust benchmarks. Given this reality, it is very important that users of LIBOR are planning their transition to the overnight risk-free benchmarks that are available, such as SOFR for the US dollar and SONIA for the British pound.

For the risk-free rates to provide an alternative to LIBOR, the next challenge is to generate sufficient liquidity in derivative products that reference the risk-free rates. This will take some time, particularly for the US dollar, where SOFR only recently started being published. Nevertheless, progress is being made, with the first futures contracts referencing SOFR recently being launched.

Market participants also need to be prepared for a scenario where the LIBOR benchmarks abruptly cease to be published. In such an event, users would have to rely on the fall-back provisions in their contracts. However, for many products the existing fall-back provisions would be cumbersome to apply and could generate significant market disruption. For instance, some existing fall-backs involve calling reference banks and asking them to quote a rate. To address this risk, the Financial Stability Board has encouraged ISDA to work with market participants to develop a more suitable fall-back methodology, using the risk-free rates that have been identified. But LIBOR is very different from an overnight risk-free rate as it includes bank credit risk and is a term rate. So the key challenge is to agree on a standard methodology for calculating credit and term spreads that can be added to the risk-free rate to construct a fall-back for LIBOR. This needs to be resolved as soon as possible, and we encourage users of LIBOR to engage with ISDA on this important work.

Finally, In Australia, the key InterBank Offer Rate benchmark for the Australian dollar is BBSW. Again we saw a spate of rate manipulations around BBSW, but the RBA and the Australian Securities and Investments Commission (ASIC) have been working closely with industry to ensure that it remains robust. The RBA argues the critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day to calculate a robust benchmark. Australia has an active bank bill market, where the major banks issue bills as a regular source of funding, and a wide range of wholesale investors purchase bills as a liquid cash management product.

They think that BBSW can continue to exist even if credit-based benchmarks, such as LIBOR, are discontinued in other jurisdictions. But in the event that LIBOR was to be discontinued, with contracts transitioning to risk-free rates, there may be some corresponding migration away from BBSW towards the cash rate. This will depend on how international markets for products such as derivatives and syndicated loans end up adapting in a post-LIBOR world.

The infrastructure is already in place for BBSW and the cash rate to coexist as the key interest rate benchmarks for the Australian dollar. The OIS market is linked to the cash rate and has been operating for almost 20 years. It already has good liquidity at the short end, and the infrastructure is there for longer term OIS. A functioning derivatives market for trading the basis between the benchmarks is important for BBSW and the cash rate to smoothly coexist. Such a basis swap market is also in place, allowing market participants to exchange the cash flows under these benchmarks.

So the bottom line is that these Interbank Offer Rates are not as immutable as might be imagined, and this uncertainty is likely to continue for some time to come.

U.S. 10-Year Treasury Yield Hits Highest Level Since 2011

U.S. government 10-year bond yields rose to their highest level since 2011 on Tuesday and the two-year yield hit its highest since 2008 as traders continued to price in a faster pace of rate hikes by the Federal Reserve this year.

The yield on 10-year U.S. Treasury notes rose as high as 3.095, the highest level since August 2011. Bond yields move inversely to prices. Two-year Treasury yields rose as high as 2.56%, their highest since 2008. The yield on the 30-year Treasury note was also higher at 3.191%.

Mortgage rates in the US also moved higher.Yields were boosted after a report on U.S. retail sales for April indicated that consumer spending is on track to rebound after a soft patch in the first quarter.

The Commerce Department reported that retail sales rose 0.3% in April, while the prior months figure was revised up to 0.8% from a previously reported 0.6%.

Yields have climbing higher since the Fed said on at its May meeting that inflation is moving closer to its 2% target.

The Fed raised rates in March and projected two more rate hikes this year, although many investors see three hikes as possible.