Markets are beginning to ask whether companies will be capable of passing on higher costs to the U.S.’ less than financially robust middle class, according to Moodys.
The U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a leveling off of global business activity.
Missing from last week’s discussion of a record ratio of U.S. nonfinancial-corporate debt to GDP was any mention of 2017’s near-record high ratio of total U.S. private and public nonfinancial-sector debt relative to GDP. The yearlong averages of 2017 showed $49.05 trillion of total nonfinancial-sector debt and $19.74 trillion of nominal GDP that put nonfinancial-sector debt at 249% of GDP—or just a tad under 2016’s record 250%.
The leveraging up of the U.S. economy has coincided with a downshifting of U.S. economic growth. From 1961 through 1979, U.S. real GDP expanded by an astounding 3.9% annually, on average, while total nonfinancial-sector debt approximated 133% of nominal GDP. When real GDP’s average annual rate of growth eased to the 3.2% of 1979-2000, the ratio of nonfinancial-sector debt to GDP rose to 176%. Since the end of 2000, U.S. economic growth has averaged only 1.8% annually and, in a possible response to subpar growth, nonfinancial-sector debt has soared to 232% of GDP
High Systemic Leverage Reins in Benchmark Yields
Over time, the record shows that the climb by the moving 10-year ratio of nonfinancial-sector debt to GDP has been accompanied by a declining 10-year moving average for the 10-year Treasury yield. For example, as the moving 10-year ratio of debt to GDP rose from 1997’s 183% to 2017’s 245%, the 10-year Treasury yield’s moving 10-year average fell from 7.31% to 2.59%.
Two factors may be at work. First, lower interest rates encourage an increase in balance-sheet leverage. Second, to the degree an elevated ratio of debt to GDP heightens the economy’s sensitivity to an increase in interest rates, lofty readings for leverage limit the upside for interest rates. Moreover, as shown by the historical record, if higher leverage tends to occur amid a slower underlying pace of economic growth, then the case favoring relatively low interest rates amid high leverage is strengthened.
None of this dismisses the possibility of an extended stay above 3% by the 10-year Treasury yield. Instead, today’s record ratio of debt to GDP warns of greater downside risk for business activity whenever interest rates enter into a protracted climb.
Today we examine the Mortgage Industry Omnishambles. And it’s more than just a flesh wound!
Welcome to the Property Imperative Weekly to 17th March 2018. Watch the video, or read the transcript.
In this week’s review of property and finance news we start with the latest January data from the ABS which shows lending for secured housing rose 0.14% or 28.8 million to $21.1 billion. Secured alterations fell 1%, down $3.9 million to $391 million. Fixed personal loans fell 0.1%, down $1.2 million to $4.0 billion, while revolving loans fell 0.06%, down $1.3 million to $2.2 billion.
Investment lending for construction of dwellings for rent rose 0.86% or $10 million to $1.2 billion. Investment lending for purchase by individuals fell 1.34%, down $127.7 million to $9.4 billion, while investment lending by others rose 7.7% up $87.2 million to $1.2 billion.
Fixed commercial lending, other than for property investment rose 1.25% of $260.5 million to $21.1 billion, while revolving commercial lending rose 2.5% or $250 million to $10.2 billion.
The proportion of lending for commercial purposes, other than for investment housing was 45% of all commercial lending, up from 44.5% last month.
The proportion of lending for property investment purposes of all lending fell 0.1% to 16.6%.
So, we are seeing a rotation, if a small one, towards commercial lending for more productive purposes. However, lending for property and for investment purposes remains quite strong. No reason to reduce lending underwriting standards at this stage or weaken other controls.
But this also explains the deep rate cuts the banks are now offering – even to investors – ANZ Bank and the National Australia Bank were the last of the big four to announce cuts to their fixed rates, following similar announcements from the Commonwealth Bank and Westpac. NAB has dropped its five-year fixed rate for owner-occupied, principal and interest home loans by 50 basis points, from 4.59 per cent to 4.09 per cent. The bank has also reduced its fixed rates on investor loans by up to 35 basis points, with rates starting from 4.09 per cent. And last week ANZ also dropped fixed rates on its “interest in advance”, interest-only home loans by up to 40 basis points, with rates starting from 4.11 per cent. Further, fixed rates on its owner-occupied, principal and interest home loans have fallen by 10 basis points, with rates now starting from 3.99 per cent. This fixed rate war shows our big banks are not pricing in a rate hike anytime soon.
But we think these offers will likely encourage churn among existing borrowers, rather than bring new buyers to the market. For example, the ABS housing finance data showed that in original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments rose to 18.0% in January 2018 from 17.9% in December 2017 – and this got the headline from the real estate sector, but the absolute number of first time buyers fell, thanks mainly to falls of 22.3% in NSW and of 13.3% in VIC. More broadly, there were small rises in refinancing and investment loans for entities other than individuals.
The latest data from CoreLogic shows home prices fell again this week, with Sydney down for the 27th consecutive week, and their index registering another 0.09% drop, whilst auction volumes were down on last week. They say that last week, the combined capital city final auction clearance rate fell to 63.3 per cent across a lower volume of auctions with 1,764 held, down from the 3,026 auctions over the week prior when a slightly higher 63.6 per cent cleared. The weighted average clearance rate has continued to track lower than results from last year; when over the corresponding week 75.1 per cent of the 1,473 auctions sold.
But the strategic issues this week relate to the findings from the Royal Commission and from the ACCC on mortgage pricing. I did a separate video on the key findings, but overall it was clear that there are significant procedural, ethical and even legal issue being raised by the Commission, despite their relatively narrow terms of reference. They cannot comment on bank regulation, or macroprudential, but the Inquiries approach is to examine a series of case studies, from the various submissions they have received, and then apply forensic analysis to dig into the root causes examining misconduct. The question of course is, do the specific examples speak to wider structural questions as we move from the specific instances. We discussed this on ABC Radio this week.
From NAB we heard about referrer’s providing leads to the Bank, outside normal lending practices and processes, and some receiving large commissions, despite not being in the ambit of the responsible lending code. From CBA we heard that the bank was aware of the conflict brokers have especially when recommending an interest only loan, because the trail commission will be higher as the principal amount is not repaid. And from Aussie, we heard about their reliance on lenders to trap fraud, as their own processes were not adequate. And we also heard of examples of individual borrowers receiving loans thanks to poor conduct, or even fraud. We also heard about how income and expenses are sometimes misrepresented. So, the question is, do these various practices show up more widely, and what does this say about liar loans, and mortgage systemic risk?
We always struggled to match the data from our independent household surveys with regards to loan to income, and loan to value, compare with loan portfolios we looked at from the banks. Now we know why. In some cases, income is over stated, expenses are understated, and so loan serviceability is a potentially more significant issue than the banks believe – especially if interest rates rise. In fact, we saw very similar behaviours to the finance industry in the USA before the GFC, suggesting again we may see the same outcomes here. One other point, every lender is now on notice that they need to look at their current processes and back book, to test affordability, serviceability and risk. This is a big deal.
I will also be interested to see if the Commission turns to look at foreclosure activity, because this is the other sleeper. Mortgage delinquency in Australia appears very low, but we suspect this is associated with heavy handed forced sales. Something again which was apparent around the GFC.
More specifically, as we said in a recent blog, the role and remuneration models for brokers are set for a significant shakedown.
Turning to the ACCC report on mortgage pricing, this was also damming. Back in June 2017, the banks indicated that rate increases were primarily due to APRA’s regulatory requirements, but now under further scrutiny they admitted that other factors contributed to the decision, including profitability. Last December, the ACCC was called on by the House of Representatives Standing Committee on Economics to examine the banks’ decisions to increase rates for existing customers despite APRA’s speed limit only targeting new borrowers. The investigation falls under the ACCC’s present enquiry into residential mortgage products, which was established to monitor price decisions following the introduction of the bank levy. Here are the main points.
Banks raised rates to reach internal performance targets: concern about a shortfall relative to performance targets was a key factor in the rate hikes which were applied across the board. Even small increases can have a significant impact on revenue, the report found. And the majority of existing borrowers would likely not be aware of small changes in rates and would therefore be unlikely to switch.
A shared interest in avoiding disruption: Instead of trying to increase market share by offering the lowest interest rates, the big four banks were mainly preoccupied and concerned with each other when making pricing decisions. It shows a failure in competition (my words).
Reputation is everything: The banks it seems were very conscious of how they should explain changes. As it happens, blaming the regulators provides a nice alibi/
For Profit: Internal memos also spoke of the margin enhancement equating to millions of dollars which flowed from lifting investment loans.
New Loans are cheaper, legacy rates are not. Banks of course are offering deep discounts to attract new customers, funded by the back book repricing. The same, by the way, is true for deposits too.
The Australian Bankers Association “silver lining” statement on the report said they welcomed the interim report into residential mortgages, which clearly shows very high levels of discounting in the Australian home loan market. It’s clear that competition is delivering better deals for customers, shopping around works and Australians should continue to do so to get the best discounts on the advertised rate. But they are really missing the point!
We will see if the final report changes, but if not these are damming, but not surprising, and again shows the pricing power the major lenders have.
So to the question of future rate rises. The FED meets this week, and the expectation is they will lift rates again, especially as the TRUMP tax cuts are inflationary, at a time when the US economy is already firing. In a recent report Fitch Ratings said that Central banks are becoming less cautious about normalising monetary policy in the face of strong growth and diminishing spare capacity. They expect the Fed to raise rates no less than seven times before the end of next year. And while still sounding tentative, the European Central Bank is clearly laying firm groundwork for phasing out QE completely later this year. They now also expect the Bank of England to raise rates by 25bp this year.
Guy Debelle, RBA Deputy Governor spoke on “Risk and Return in a Low Rate Environment“. He explored the consequences of low rates, on asset prices, and asks what happens when rates rise. He suggested that we need to be alert for the effect the rise in the interest rate structure has on financial market functioning, and that investors were potentially too complacent. There are large institutional positions that are predicated on a continuation of the low volatility regime remaining in place. He had expected that volatility would move higher structurally in the past and this has turned out to be wrong. But He thinks there is a higher probability of being proven correct this time. In other words, rising rates will reduce asset prices, and the question is – have investors and other holders of assets – including property – been lulled into a false sense of security?
All the indicators are that rates will rise – you can watch our blog on this. Rising rates of course are bad news for households with large mortgages, exacerbated by the possibility of weaker ability to service loans thanks to fraud, and poor lending practice. We discussed this, especially in the context of interest only loans, and the problems of loan resets on the ABC’s 7:30 programme on Monday. We expect mortgage stress to continue to rise.
There was more discussion this week on Housing Affordability. The Conversation ran a piece showed that zoning is not the cause of poor affordability, and neither is supply of property. Indeed planning reform they say is not a housing affordability strategy. Australia needs a more realistic assessment of the housing problem. We can clearly generate significant dwelling approvals and dwellings in the right economic circumstances. Yet there is little evidence this new supply improves affordability for lower-income households. Three years after the peak of the WA housing boom, these households are no better off in terms of affordability. In part, this may reflect that fact that significant numbers of new homes appear not to house anyone at all. A recent CBA report estimated that 17% of dwellings built in the four years to 2016 remained unoccupied. If we are serious about delivering greater affordability for lower-income Australians, then policy needs to deliver housing supply directly to such households. This will include more affordable supply in the private rental sector, ideally through investment driven by large institutions such as super funds. And for those who cannot afford to rent in this sector, investment in the community housing sector is needed. In capital city markets, new housing built for sale to either home buyers or landlords is simply not going to deliver affordable housing options unless a portion is reserved for those on low or moderate incomes.
But they did not discuss the elephant in the room – booming credit. We discussed the relative strength of different drivers associated with home price rises in a separate, and well visited blog post, Popping The Housing Affordability Myth. But in summary, the truth is banks have pretty unlimited capacity to create more loans from thin air – FIAT – let it be. It is not linked to deposits, as claimed in classic economic theory. The only limit on the amount of credit is people’s ability to service the loans – eventually. With that in mind, we built a scenario model, based on our core market model, which allows us to test the relationship between home prices, and a series of drivers, including population, migration, planning restrictions, the cash rate, income, tax incentives and credit.
We found the greatest of these is credit policy, which has for years allowed banks to magic money from thin air, to lend to borrowers, to drive up home prices, to inflate the banks’ balance sheet, to lend more to drive prices higher – repeat ad nauseam! Totally unproductive, and in fact it sucks the air out of the real economy and money directly out of punters wages, but make bankers and their shareholders richer. One final point, the GDP calculation we use in Australia is flattered by housing growth (triggered by credit growth). The second driver of GDP growth is population growth. But in real terms neither of these are really creating true economic growth. To solve the property equation, and the economic future of the country, we have to address credit. But then again, I refer to the fact that most economists still think credit is unimportant in macroeconomic terms! The alternative is to continue to let credit grow well above wages, and lift the already heavy debt burden even higher. Current settings are doing just that, as more households have come to believe the only way is to borrow ever more. But, that is, ultimately unsustainable, and this why there will be an economic correction in Australia, and quite soon. At that point the poor mortgage underwriting chickens will come home to roost. And next time we will discuss in more detail how these scenarios are likely to play out. But already we know enough to show it will not end well.
Interesting speech from Guy Debelle, RBA Deputy Governor “Risk and Return in a Low Rate Environment“. He explores the consequences of low rates, on asset prices, and asks what happens when rates rise. He suggests that we need to be alert for the effect the rise in the interest rate structure has on financial market functioning.
The recent spike in volatility is one example of this. This was a small example of what could happen following a larger and more sustained shift upwards in the rate structure. The recent episode was primarily confined to the retail market. The large institutional positions that are predicated on a continuation of the low volatility regime remain in place. He has expected that volatility would move higher structurally in the past and this has turned out to be wrong. But He thinks there is a higher probability of being proven correct this time.
In other words, rising rates will reduce asset prices, and the question is have investors and other holders of assets – including property – been lulled into a false sense of security?
Here is the speech:
Low Interest Rates
I am going to use the rate structure in the US, and particularly the yield on a US 10-year Treasury bond to illustrate the shift in the rate structure (Graph 1).
Graph 1
As you are all aware, in the wake of the financial crisis and the sharp decline in global growth and inflation, monetary policy rates round the world were reduced to historically low levels. In a number of countries (Australia being one notable exception), the policy rate was lowered to its effective lower bound, which in some cases was even in negative territory.
In part reflecting the low level of policy rates and the slow nominal growth post crisis, long-term bond yields also declined to historically low levels. 10-year government bond yields in some countries, including Germany, Japan and Switzerland have been negative at various times in recent years. In 2015, over US$14 trillion of sovereign paper had negative yields.
For the past decade, the yield structure in the US has been lower than at any time previously. Let me put in context the current excitement about the 10-year yield in the US reaching 3 per cent. In the three decades prior to 2007, the low point for the yield was 3.11 per cent.
All this goes to say that we have been living in a period of unusually low nominal bond yields. How long will this period last?
One way to think about this question is to ask whether what we are seeing is the realisation of a tail event in the historical distribution of interest rates. While this tail event has now lasted quite a long time, if you thought it was a tail event, then you would expect yields to revert back to their historical mean at some point. You also wouldn’t change your assessment of the distribution of future realisation of interest rates.
On the other hand, it might be the case that the yield structure has shifted to a permanently lower level because of (say) secular stagnation resulting in structurally lower growth rates for the major economies for the foreseeable future. If this were the case, you would change your assessment of future interest rate outcomes.
I don’t know the answer to this question, but it has material implications for asset pricing.
As I said earlier, the prices of many assets could be broadly validated if you believe the low rate structure is here to stay. This is because the lower rate structure means that the rate with which you discount expected future returns on your asset is lower and hence the asset price is higher for any given flow of future earnings.
The current constellation of asset prices seems to be based on the view that the global economy can grow strongly, with associated earnings growth, but that strong growth will not lead to any material increase in inflationary pressure.
You might want to question how long such a benign conjuncture could last. Current asset pricing suggests that the (average) expectation of market participants is that it will last for quite a while yet.
It is also worth pointing out that it is possible that a move higher in interest rates occurs alongside higher expected (nominal) dividends because of even higher real growth. If this were to occur it would not necessarily imply that asset prices have to adjust. It would depend upon the relative movements in earnings expectations and interest rates; that is, the numerator and denominator in the asset price calculation.
How might we know whether the distribution of interest rates has shifted? One can think of the interest rate distribution as being anchored by the neutral rate of interest. I talked about this in the Australian context last year. As I said then, empirically the neutral rate of interest is difficult to estimate. It is even harder to forecast. The factors which affect it are often slow moving. But sometimes they aren’t, most notably around the time of the onset of the financial crisis in 2007-08, when estimates of the neutral rate declined rapidly and significantly. Currently, there is a debate in the US as to whether the neutral rate of interest has bottomed and is shifting up. This raises the question as to the degree and speed with which such a movement in the neutral rate in the US might translate globally.
All of these questions highlight to me the inherent uncertainty about the future evolution of interest rates. One might decide that interest rates are going to continue to remain lower for longer, but I struggle to see how one can hold that view with any great certainty. Yet there appears to me to be very little, if any, compensation for this uncertainty in fixed income markets. Most estimates of the term premium in the 10-year US Treasuries are around zero, or are even negative (Graph 2). Investors are not receiving any additional compensation for holding an asset with duration.
Graph 2
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 4
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
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
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
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
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
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
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.
Conclusion
The structure of interest rates globally has been at an historically low level for a number of years. This has reflected the aftermath of the financial crisis and the associated monetary policy response. If the global recovery continues to play out as currently anticipated, one would expect that the monetary stimulus will unwind, which would see at least the short-end of yield curves rise.
At the same time, there have been factors behind the low structure of interest rates which are difficult to understand completely and raise questions about its durability. I have discussed some of them here today. In particular, I find it puzzling that there is little compensation for duration in the rate structure. While there are explanations for why interest rates may remain low for a considerable period of time, there is minimal compensation for the uncertainty as to whether or not this will actually occur. At the same time, equity prices embody a view of the future that robust growth can continue without generating a material increase in inflation. Again, there is little priced in for the risk that this may not turn out to be true.
The ongoing improvement in the global economy, together with the fiscal stimulus in the US has caused some investors to question these views. If interest rates continue to rise without a similar rise in expectations about future earnings growth, one would expect to see a repricing of other assets, particularly equity markets. Such a repricing does not necessarily mean a major derailing of the global recovery, indeed it is a consequence of the recovery, but it may have a dampening effect.
In the early hours of the morning of 7 October 2016, the sterling-US dollar exchange rate fell by nearly 10% within around 40 seconds. Most of this movement was reversed within the ten minutes that followed. This was one of a series of such ‘flash’ episodes in major financial markets – that is sharp and short-lived movements in price, which vastly exceed perceived changes in economic fundamentals. It certainly didn’t fail to catch the eye of policymakers, or the media.
Chart 1 shows data taken from this platform around the episode:
The triangles show the prices at which individual transactions took place. Those in blue (pointing down) indicate transactions initiated by a participant seeking to sell sterling. Those in green (pointing up) indicate those initiated by an order to buy.
The shaded regions show the cumulative distribution of limit orders around these prices. Limit orders are unexecuted orders to buy or sell sterling posted by prospective traders.
The relative weight of the shading on the chart shows the quantity of limit orders between a given price and the limit orders to buy/sell at the highest/lowest prices (the ‘best bid/ask prices’). As might be expected, prices further from the best bid/ask are shaded in darker colours. This indicates that there lies a larger cumulative quantity of limit orders between them and the best bid/ask.
The black line shows the midpoint – or ‘mid-price’ – between the best bid/ask prices.
From this chart we can construct a rough narrative of events:
In the minute preceding the crash, between six and seven minutes past midnight (00:06:00 and 00:07:00 British Summer Time), there was quite a large depth of orders both to buy and sell sterling (£60 million of orders in the observed ten levels of price closest to the best bid and ask prices).
But at around 00:07:00, an imbalance started to develop – with the quantity of orders to sell sterling starting to exceed those to buy.
It was at this point that a rapid succession of trades took place in sterling, at rapidly declining prices.
This imbalance became particularly severe around 00:07:17 BST. This can be seen from the large white areas in the graph, which indicate there to be (close to) no orders to buy sterling. In the half minute that followed, market functioning was severely impaired, with large ‘gaps’ in price visible between trades.
The quantity of, and balance between, limit orders to buy/sell sterling recovered after about 30 seconds but deteriorated severely again after around one minute. Shortly after 00:09 BST, there was a further sharp reduction in orders to buy sterling (corresponding to another white area on the chart).
The order book started to increase in depth around 00:09:30 BST, around 150 seconds after the initial sharp movement in price.
Thankfully, the events of the night of 7 October 2016 were without lasting consequences for financial stability, or the integrity of the functioning of the market for sterling. Higher than usual volumes were observed during the day that followed, and measures of illiquidity (including bid-ask spreads) remained slightly elevated; but broader spill overs were generally limited.
That, however – understandably – hasn’t stopped the search for answers.
…and why?
In its report on the episode, the Bank for International Settlements (2017) found the movement in the currency pair to have resulted from a confluence of factors. These included larger-than-normal trading (predominantly selling) volumes at a typically illiquid part of the trading day. There were also sales of sterling by some market participants seeking to limit the risk associated with their positions in options markets, and to execute client orders in response to the initial fall in the exchange rate.
One important outstanding question is the degree to which the change in price witnessed during the episode was in line with the imbalance between observed orders to buy and sell.
The blue bar in Chart 2 shows the range of estimates of change in price given by this model, when calibrated to past movements in the sterling dollar exchange rate. These imply that the observed orders to sell sterling during the flash episode are consistent with a decrease in the sterling-US dollar exchange rate of between 1.03% and 2.87%, depending on the precise choice of parameters.
Chart 2: The (in)consistency between observed changes in price and those expected given observed orders to buy/sell sterling
The dots in the right-hand columns compare these estimates with the observed decline in the exchange rate. The purple triangle shows that which took place early in the episode, between 00:07:00 and 00:07:15 (roughly step (2), above). The yellow square shows the peak-to-trough fall in sterling over the entirety of the episode.
From this we can see:
The initial fall in sterling, during the early part of the episode, of 1.8%, is consistent with the range of estimates based on the observed imbalance of orders. This suggests that the movement in price was consistent with the arrival of a large order to sell sterling.
But the larger change in price that occurred between 00:07:00 to 00:07:17 cannot be explained by expected price impact of trades alone.
Was there another factor at play?
That the overall fall in sterling so vastly exceeds that predicted by our model might suggest that some some other driver might have been at play.
The report by the BIS suggests a number of other factors that might have played a role in reducing available liquidity during the episode. These include the temporary withdrawal of some market participants from their role as market makers. This dynamic may have, in part, reflected the presence of staff with lower risk limits and appetite at some institutions at that time of day. An automatic pause in trading in sterling futures contracts may also have led to a reduction of liquidity in the cash market, because some market makers are thought to rely on futures as a guide to the price at which they offer to buy/sell currency in cash markets. It is, however, difficult to know what weight to place on these different explanations.
All else equal, such a reduction in liquidity would have increased the resulting fall in price beyond that estimated to be in line with observed trading volume.
Conclusion
The events of 7 October 2016 represented one of a series of flash events occurring in electronically traded markets. No such events have, as yet, had longer lasting consequences for market functioning or stability.
Nonetheless, policymakers have recently pointed to the clear onus on central banks and the regulatory community to understand developments in these markets, and how they behave during periods of stress.
This work represents one step in that effort.
Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees
A strengthening world economy and rising corporate confidence pushed global dividends to a new high in 2017, according to the latest Janus Henderson Global Dividend Index. They rose 7.7% on a headline basis, the fastest rate of growth since 2014, and reached a total of $1.252 trillion.
Underlying growth, which adjusts for movements in exchange rates, one-off special dividends and other factors, was an impressive 6.8%, and showed less divergence than in previous years across the different regions of the world, reflecting the broadly based global economic recovery.
Every region of the world and almost every industry saw an increase. Moreover, records were broken in 11 of the index’s 41 countries, among them the United States, Japan, Switzerland, Hong Kong, Taiwan, and the Netherlands.
In Australia, dividends rose to $53.3bn, an increase of 9.7% on an underlying basis. The big story was the return of the mining companies, following rapid improvements in their profits and balance sheet. Between them, BHP and Rio Tinto added $2.9bn, accounting for two-thirds of all Australia’s dividend growth.
Among the banks, which pay more than half of all Australian dividends, and which have very high payout ratios, only Commonwealth Bank increased slightly year-on-year. Even so, no Australian company in our index cut its dividend, though QBE Insurance further reduced the tax credit it was able to provide, meaning that investors received less year-on-year after tax.
In 2017, CBA was the world’s 13th dividend payer (down from 12th the previous year), the only Australian firm in the top 20 according to the JH research.
2017 was a record year for Asia Pacific ex Japan. The total paid
jumped 18.8% to $139.9bn, boosted by exceptionally large special dividends in Hong Kong, of which the biggest by far was from China Mobile. Even allowing for these, and other factors elsewhere in the region, underlying growth was impressive at 8.6%. The jump in dividends paid in the region was just enough to push it ahead of North America as the fastest growing region since 2009.
They say that strong earnings growth around the world in 2018 will support continued dividend increases, with 6.1% underlying growth, with every region seeing an increase, plus a weaker dollar means expected headline growth of 7.7%, bringing total global dividends of $1.348 trillion in 2018.
Methodology.
Each year Janus Henderson analyses dividends paid by the 1,200 largest firms by market capitalisation (as at 31/12 before the start of each year). Dividends are included in the model on the date they are paid. Dividends are calculated gross, using the share count prevailing on the pay-date (this is an approximation because companies in practice fix the exchange rate a little before the pay date), and converted to USD using the prevailing exchange rate.
The findings of the surveillance are outlined in REP 566 Surveillance of Credit Rating Agencies.
ASIC’s main areas of focus were the CRAs’ governance arrangements (including relating to conflicts of interest and their corporate structure), transparency and disclosure.
ASIC’s report makes a number of observations about CRAs’ activities with some leading to recommendations for change in areas such as board reporting, compliance teams and compliance testing, analytical evaluation of ratings and human resources.
ASIC Commissioner Cathie Armour said, ‘CRAs play an important role in our market by giving market users, for example, investors, issuers and governments, a better understanding of credit risks and informing their investment and financing decisions
‘While many of the CRAs operate in a global market with global standards, it is important that they do not lose sight of their regulatory obligations in Australia’, Ms Armour said.
ASIC is actively engaged internationally on policy development for credit rating agencies through its membership of the International Organization of Securities Commissions (IOSCO) and participates in supervisory colleges for the three large international CRAs – Fitch, Moody’s and S&P. Supervisory colleges were established to facilitate the exchange of information between the supervisors of internationally active CRAs in order to foster more effective supervision of these firms.
Background
Under the Corporations Act, CRAs are required to hold an Australian financial services (AFS) licence and to comply with the conditions of the licence, including requirements to comply with the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. CRAs are also required to provide assistance to ASIC, including in relation to their compliance with the Corporations Act.
There are currently six licensed CRAs operating in Australia and they all formed part of the surveillance – A.M Best Asia-Pacific Limited, Australia Ratings Pty Ltd, Equifax Australasia Credit Ratings Pty Limited, Fitch Australia Pty Limited, Moody’s Investor Services Pty Limited and S&P Global Ratings Australia Pty Ltd.
World growth prospects remain very strong for 2018 and are unlikely to be derailed by recent financial market volatility, but the balance of inflation risks is shifting, with implications for monetary policy, says Fitch Ratings in its latest Global Economic Update report.
Data released since Fitch’s December 2017 Global Economic Outlook (GEO) show world growth to have recovered even more rapidly than previously thought in 2017 and confirm that momentum has been maintained in early 2018, supported by rising investment, buoyant world trade, loose financial conditions and pro-cyclical fiscal easing.
“Economic slack is diminishing rapidly, and against a backdrop of an even stronger global recovery last year than we thought, market concerns over inflation and forthcoming monetary policy adjustments have risen. This has sparked a rise in global bond yields and significant equity market volatility. But we see this primarily as a correction to an overly sanguine view on the US interest rate outlook rather than signalling any serious threat of a sharp economic slowdown,” said Brian Coulton, Fitch’s Chief Economist.
The rise in oil prices in the aftermath of the extension of OPEC quota reductions, sharp falls in Venezuela’s oil production and declining global crude inventories also adds risks to headline inflation. While we still expect the strong supply response from US shale producers to continue, there are upside risks to our USD52.5/bbl (Brent) oil price forecast for 2018.
The Fed looks increasingly likely to raise rates four times in 2018 following upgrades to its growth forecasts. Concerns about low core inflation have eased and will be further assuaged by the recent pick-up in US wage inflation to an eight-year high of 2.9%. The ECB is sounding much more confident about economic recovery and has acknowledged the recent acceleration in wages, even though core CPI inflation remains below the bank’s comfort zone at 1%. Net asset purchases at EUR30 billion per month through September 2018 are still the base case, but the chances of any extension or upscaling are diminishing and ECB forward guidance is likely to start reflecting this in March. Better-than-expected UK growth increases the chance of a further Bank of England rate increase this year as low unemployment reduces the bank’s tolerance for above-target inflation.
US GDP grew by 2.5% annualised in 4Q17, broadly in line with our GEO forecast. Private domestic demand growth now exceeds 3% on an annual basis, led by a pick-up in business investment. The capex recovery is boosting US imports, imparting a drag on GDP growth from net trade. Nevertheless, with the final tax package worth 0.7% of GDP in its first year, domestic demand is likely to accelerate this year and there are modest upside risk to the GEO growth forecast of 2.5%.
Eurozone GDP grew by 0.6% in 4Q17, in line with our GEO forecast. However, upward revisions to previous quarters saw the 2017 annual outturn hit 2.5%, the strongest growth rate since 2007. PMI surveys remain at very elevated levels, and the ECB’s January bank lending survey showed increasing loan demand from firms. The latter is consistent with an increasingly buoyant outlook for eurozone capex as conditions for SMEs improve, bank lending picks up, and economic and political uncertainties subside.
The strength of the eurozone economy was an important factor supporting UK growth in 4Q17, when GDP expanded by a faster-than-expected 0.5%, taking 2017 annual GDP growth to 1.8%, 0.2pp faster than anticipated. Japan’s 4Q17 GDP data has yet to be released, but upward revisions to earlier quarters and buoyant monthly data point to 2017 growth having beaten the GEO estimate of 1.5% and to upside risks for 2018.
China’s economy grew by 6.8% yoy and by 1.6% qoq in 4Q17. These rates were in line with our GEO forecasts, but upward revisions to preceding quarters pushed 2017 annual growth up to 6.9%, the first incremental increase since 2010. The slowdown in credit and housing sales in late 2017 was consistent with weakening sequential GDP growth through the year (from 1.9% qoq in 2Q17) and points to some mild further slowing ahead.
Back in April 2017, the IMF released a Financial Stability Report update which said that “in the United States, if the anticipated tax reforms and deregulation deliver paths for growth and debt that are less benign than expected, risk premiums and volatility could rise sharply, undermining financial stability”.
They said that more than 20% of US firms would find it hard to service their debts, if rates rose – and yes, now rates are rising! This puts pressure on companies, and on their banks. This is no “flash crash”, it’s structural!
Under a scenario of rising global risk premiums, higher leverage could have negative stability consequences. In such a scenario, the assets of firms with particularly low debt service capacity could rise to nearly $4 trillion, or almost a quarter of corporate assets considered.
The number of US firms with very low interest coverage ratios—a common signal of distress—is already high: currently, firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (Panel 5).
This figure doubles to 20 percent of corporate assets when considering firms that have slightly higher earnings cover for interest payments, and rises to 22 percent under the assumed interest rate rise. The stark rise in the number of challenged firms has been mostly concentrated in the energy sector, partly as a result of oil price volatility over the past few years. But the proportion of challenged firms has broadened across such other industries as real estate and utilities. Together, these three industries currently account for about half of firms struggling to meet debt service obligations and higher borrowing costs (Panel 6).
Recent events have the potential to create a revolution in Australian Finance. We explore the 72 hours that changed banking forever.
Welcome to the Property Imperative Weekly to 10th February 2018.Watch the video or read the transcript.
In our latest weekly digest, we start with the batch of new reports, all initiated by the current Australian Government – and which combined have the potential to shake up the Financial Services sector, and reduce the excessive market power which the four major incumbents have enjoyed for years.
On Wednesday, the Productivity Commission, Australian Government’s independent research and advisory body released its draft report into Competition in the Australian Financial System. It’s a Doozy, and if the final report, after consultation takes a similar track it could fundamentally change the landscape in Australia. They leave no stone unturned, and yes, customers are at a significant disadvantage. Big Banks, Regulators and Government all cop it, and rightly so. They say, Australia’s financial system is without a champion among the existing regulators — no agency is tasked with overseeing and promoting competition in the financial system. It has also found that competition is weakest in markets for small business credit, lenders’ mortgage insurance, consumer credit insurance and pet insurance. The report demonstrates the inter-linkages between difference financial entities, and their links to the four majors. They criticised mortgage brokers and financial advisers for poor advice (influenced by commission and ownership structures) and the regulatory environment, where the shadowy Council of Finance Regulators (RBA, ASIC, APRA and Treasury) do not even release minutes of the meetings which set policy direction. You can watch our separate video blog on this.
On Thursday, the Treasurer released draft legislation to require the big four banks to participate fully in the credit reporting system by 1 July 2018. They say this measure will give lenders access to a deeper, richer set of data enabling them to better assess a borrower’s true credit position and their ability to pay a loan. This removes the current strategic advantage which the majors have thanks to the credit data asymmetry, and the current negative reporting. We note that there is no explicit consumer protection in this bill, relating to potential inaccuracies of data going into a credit record. This is, in our view a significant gap, especially as the proposed bulk uploading will require large volumes of data to be transferred. It does however smaller lenders to access information which up to now they could not, so creating a more level playing field. Consumers may benefit, but they should also beware of the implications of the proposals.
On Friday, Treasurer Morrison released the report by King & Wood Mallesons partner Scott Farrell in to open banking which aims to give consumers greater access to, and control over, their data and which mirrors developments in the UK. This “open banking” regime mean that customers, including small businesses, can opt to instruct their bank to send data to a competitor, so it can be used to price or offer an alternative product or service. Great news for smaller players and fintechs, and possibly for customers too. Bad news for the major players. The report recommends that the open banking regime should apply to all banks, though with the major banks to join it first. For non-banks and fintechs, the report wants a “graduated, risk-based accreditation standard”. Superannuation funds and insurers are not included for now. In terms of implementation, data holders should be required to allow customers to share information with eligible parties via a dedicated application programming interface, not screen scraping. A period of approximately 12 months between the announcement of a final Government decision on Open Banking and the Commencement Date should be allowed for implementation. From the Commencement Date, the four major Australian banks should be obliged to comply with a direction to share data under Open Banking. The remaining Authorised Deposit-taking Institutions should be obliged to share data from 12 months after the Commencement Date, unless the ACCC determines that a later date is more appropriate.
Then of course the Royal Commission in Financial Services starts this coming week. We discussed this on ABC The Business on Thursday. Lending Practice is on the agenda, highly relevant given the new UBS research (they of liar loans) suggesting that incomes of many more affluent households are significantly overstated on mortgage application forms. And The BEAR – the bank executive behaviour regime legalisation – passed the Senate, and as a result of amendments, Small and medium banking institutions have until 1 July 2019 to prepare for the BEAR while it will commence for the major banks on 1 July 2018.
APRA Chairman Wayne Byers spoke at the A50 Australian Economic Forum, Sydney. Significantly, he says the temporary measures taken to address too-free mortgage lending will morph into the more permanent focus on among other things, further strengthening of borrower serviceability assessments by lenders, strengthened capital requirements for mortgage lending, and the comprehensive credit reporting being mandated by the Government.
Adelaide Bank is ahead of the curve, as it introducing an alert system that will monitor property borrowers that are struggling with their repayments. The bank and its subsidiaries and affiliates will compare monthly mortgage repayments with borrowers’ income ratios. In addition, extra scrutiny will be applied where the loan-to-income ratio exceeds five times or monthly mortgage repayments exceed 35% of a borrower’s income.
But combined, data sharing, positive credit and banking competition and regulation are all up in the air, or are already coming into force and in each case it appears the big four incumbents are the losers, as they are forced to share customer data, and competition begins to put their excessive profitability under pressure. It highlights the dominance which our big banks have had in recent years, and the range of reforms which are in train. The face of Australian Banking is set to change, and we think customers will benefit. But wait for the rear-guard actions and heavy lobbying which will take place ahead.
Of course the RBA left the cash rate on hold this week, and signalled the next move will likely be up, but not for some time. Retail turnover for December fell 0.5% according to the ABS seasonally adjusted. This is the headline which will get all the coverage, but the trend estimate rose 0.2 per cent in December 2017 following a rise of 0.2 per cent in November 2017. Compared to December 2016 the trend estimate rose 2.0 per cent. This is in line with average income growth, but not good news for retailers.
The latest Housing Finance Data from the ABS shows a fall in flows in December. In trend terms, the total value of dwelling finance commitments excluding alterations and additions fell 0.1% or $31 million. Owner occupied housing commitments rose 0.1% while investment housing commitments fell 0.5%. Owner occupied flows were worth $14.8 billion, and down 0.3% last month, while owner occupied refinancing was $6.2 billion, up 1.2% or $73 million. Investment flows were worth 11.9 billion, and fell 0.5% or $62 million. The percentage of loans for investment, excluding refinancing was 45%, down from 49% in Dec 2016. Refinancing was 29.5% of OO transactions, up from 29.2% last month. Momentum fell in NSW and VIC, the two major states. In original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments fell to 17.9% in December 2017 from 18.0% in November 2017 – the number of transactions fell by 1,300 compared with last month. But the ABS warns that the First Time Buyer data may be revised and users should take care when interpreting recent ABS first home buyer statistics. The ABS plans to release a new publication which will see Housing Finance, Australia (5609.0) and Lending Finance, Australia (5671.0) combined into a single, simpler publication called Lending to Households and Businesses, Australia (5601.0).
We continue to have data issues with mortgage lending, with the RBA in their new Statement on Monetary Policy saying it now appears unnecessary to adjust the published growth rates to undo the effect of regular switching flows between owner occupied and investment loans as they have been doing for the past couple of years. So now investor loan growth on a 6-month basis has been restated to just 2%. More fluff in the numbers! Additionally, the RBA will publish data on aggregate switching flows to assist with the understanding of this switching behaviour.
More data this week highlighting the pressures on households. National Australia Bank’s latest Consumer Behaviour Survey, shows the degree of anxiety being caused by not only cost of living pressures but also health, job security, retirement funding as well as Australian politics. Of all the things bothering Australian households in early 2018, nothing surpasses cost of living pressures. Over 50% of low income earners reported some form of hardship, with almost one in two 18 to 49-year-olds being effected.
Despite improved job conditions and households reporting healthier financial buffers, the overall financial comfort of Australians is not advancing, according to ME’s latest Household Financial Comfort Report. In its latest survey, ME’s Household Financial Comfort Index remained stuck at 5.49 out of 10, with improvements in some measures of financial comfort linked to better employment conditions – e.g. a greater ability to maintain a lifestyle if income was lost for three months – offset by a fall in comfort with living expenses.
We released the January 2018 update of our Household Financial Confidence Index, using data from our rolling 52,000 household surveys. The news is not good, with a further fall in the composite index to 95.1, compared with 95.7 last month. This is below the neutral setting, and is the eighth consecutive monthly fall below 100. Costs of living pressures are very real, with 73% of households recording a rise, up 1.5% from last month, and only 3% a fall in their living costs. A litany of costs, from school fees, child care, fuel, electricity and rates all hit home. You can watch our separate video on this.
We also published updated data on net rental yields this week, using data from our household surveys. Gross yield is the actual rental stream to property value, net rental is rental payments less the costs of funding the mortgage, management fees and other expenses. This is calculated before any tax offsets or rebates. The latest results were featured in an AFR article. The results are pretty stark, and shows that many property investors are underwater in cash flow terms – not good when capital values are also sliding in some places. Looking at rental returns by states – Hobart and Darwin are the winners; Melbourne, and the rest of Victoria, then Sydney and the rest of NSW the losers. The returns vary between units and houses, with units doing somewhat better, and we find some significant variations at a post code level. But we found that more affluent households are doing significantly better in terms of net rental returns, compared with those in more financially pressured household groups. Batting Urban households, those who live in the urban fringe on the edge of our cities are doing the worst. This is explained by the types of properties people are buying, and their ability to select the right proposition. Running an investment property well takes skill and experience, especially in the current rising interest rate and low capital growth environment. Another reason why prospective property investors need to be careful just now.
Finally, we saw market volatility surge, as markets around the world gyrated following the “good news” on US Jobs last week, which signalled higher interest rates. In our recent video blog we discussed whether this is a blip, or something more substantive. We believe it points to structural issues which will take time to play out, so expect more uncertainly, on top of the correction which we have already had. This will put more upward pressure on interest rates, and also on bank funding here.
Overall then, a week which underscores the uncertainly across the finance sector, and households. This will not abate anytime soon, so brace for a bumpy ride. And those managing our large banks will need to adapt to a fundamentally different, more competitive landscape, so they are in for some sleepless nights.
If you found this useful, do like the post, add a comment and subscribe to receive future updates. Many thanks for taking the time to watch.
Thus far, the corporate credit market has been relatively steady amid equity market turmoil. Corporate credit’s comparative calm stems from expectations of continued profit growth that underpins a still likely slide by the high-yield default rate. The record shows that 90% of the year-to-year declines by the default rate were joined by year-to-year growth for the market value of U.S. common stock.
Today’s positive outlooks for business sales and operating profits suggest that equities will recover once issues pertaining to interest rates are sufficiently resolved. For now, equities may be paying dearly for having been more richly priced vis-a-vis fundamentals when compared to corporate bonds.
Since the VIX index’s current estimation methodology took effect in September 2003, the high-yield bond spread has generated a strong correlation of 0.90 with the VIX index. However, for now that ordinarily tight relationship has broken down. Never before has the high-yield bond spread been so unresponsive to a skyrocketing VIX index.
The VIX index’s 28.5-point average of February-to-date has been statistically associated with an 832-basis-point midpoint for the high-yield bond spread. Instead, the high-yield bond spread recently approximated 353 bp. Thus, the high-yield spread predicted by the VIX index now exceeds the actual spread by a record 479 bp.
The old record high gap was the 364 bp of October 2008, or when the actual spread of 1,398 bp would eventually surpass the 1,762 bp predicted by the VIX index. Not long thereafter, the actual high-yield spread would peak at the 1,932 bp of December 2008.
More recently, or during the euro zone crisis of 2011, the 1,018 bp high-yield spread predicted by the VIX index was as much as 323 bp above August 2011’s actual spread of 695 bp. After eventually peaking at October 2011’s 775 bp, the spread narrowed to 590 bp by August 2012.
What transpired following August 2011 and October 2008 warns against being too quick to dismiss the possibility of at least a 100 bp widening by the latest high-yield spread. Nevertheless, high-yield spreads would be significantly thinner one year after the gap between the predicted and actual spreads peaked.
For example, by August 2012, the high-yield spread had narrowed to 590 bp, while the spread had thinned to 737 bp by October 2009.
