Guy Debelle: Global and domestic influences on the Australian bond
market
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, at the KangaNews Debt Capital Markets Summit 2015, Sydney, 16 March 2015.
* * *
I would like to thank Emma Doherty, Suchita Mathur and John Boulter for their assistance in preparing these
remarks.
Accompanying graphs can be found at the end of the speech.
Today I will talk about some of the global and domestic factors that are influencing conditions
in the Australian bond market. I'll start with a discussion on the decline in global bond yields
that we've seen over the past year or so before turning to focus on how these and other
developments have played out in the Australian bond market. I will finish with some recent
and prospective regulatory developments affecting the local market.
Global influences
At the beginning of 2014, the 10-year Treasury yield in the US was around 3 per cent. At that
yield, investors were getting some compensation for duration risk in the form of a term
premium; that is, some compensation for uncertainty about the future path of US monetary
policy. However, over the course of 2014 the yield declined steadily, reaching a low of
1.64 per cent in early 2015, close to the historical lows reached in July 2012. With a yield of
1.64, investors were getting little or no compensation for term risk or the risk of inflation.
Indeed, one could argue that the term premium was even negative. There was no meaningful
compensation for uncertainty about the path of US monetary policy or inflation.
This decline in US yields was also evident in nearly all advanced economies and occurred
despite some notable variations across countries at the shorter end of the curve (Graph 1).
Over recent months, it has looked more like yields in Germany driving those in the US and
elsewhere rather than the traditional relationship of US yields driving those in other markets.
In recent weeks, some of the decline in yields has been unwound in the US and a few other
economies such as the UK, but 10-year yields in the euro area have fallen further to reach
new historic lows, with the 10-year yield in Germany now noticeably below that in Japan. As
has been remarked on frequently, the 10-year yields in Spain and Ireland are currently below
that in the US.
At the shorter end of the yield curve, expectations for future monetary policy settings are an
important driver. There has been a notable divergence in expectations for the path of
monetary policy in major developed economies since the middle of 2013. In the US, the Fed
gradually slowed the pace of its asset purchases from January 2014 and ceased them
altogether in October. More recently, it has indicated that it is getting closer to raising the
level of the federal funds rate target for the first time in nearly a decade.
In contrast, over the same period the European Central Bank (ECB) has moved to further
loosen monetary policy settings in the euro area, culminating with the announcement in early
2015 of a sovereign bond purchase program. Several European countries that are not
members of the euro area have lowered the interest rate paid on deposits with the central
bank to negative territory, a move that the ECB made in September 2014. Meanwhile, the
Bank of Japan (BoJ) has continued its quantitative easing program, increasing the scale of
its asset purchases in late October.
The influence of this divergence in monetary policy on the relevant sovereign bond markets
is evident in the movements in yields on 2-year government bonds over the past 18 months
(Graph 2). In particular, 2-year US Treasury yields have risen a little since late 2013 while
2-year German government bond yields have declined steadily and turned negative.
At the longer end of the curve, as I noted earlier, the trajectory of sovereign yields has been
more uniform, with the implied yield on a 5-year bond starting in 5 years' time (the 5-year,
5-year-forward yield) falling consistently throughout 2014. The uniformity of these
movements suggests that global factors have played a role. While it is straightforward to
come up with explanations for the direction of movement in yields, I do not find any of them
compelling in explaining the size of the downward movement.
One possible contributor to the decline in yields has been concerns about the global growth
outlook, but expectations for global growth over the medium term haven't changed all that
much. Secular stagnation is also another popular explanation as lower real growth implies
lower real yields (although I am more optimistic about the world than the one this theory
implies). Yields may also have been influenced by the prospective reduced supply of
government bonds: the gradual improvement in governments' fiscal positions is reducing
funding needs and government bond issuance. At the same time, the quantitative easing
programs of the ECB and the BoJ have also worked to increase actual and anticipated
demand for bonds, and there is increased demand from banks to hold sovereign debt to
meet liquidity requirements. While the Fed is no longer making net purchases, it has
indicated that it will keep the stock of its asset holdings constant for some time by reinvesting
maturing holdings in US Treasuries.
One remarkable outcome is that a large proportion of developed countries' government
bonds are now trading at negative yields in secondary markets. Two-thirds of the German
and Swiss government bonds on issue are currently trading at negative yields, while yields
on bonds of up to five years in maturity from the Japanese and a variety of European
governments have recently traded at negative yields.
Five-year, 5-year-forward real yields have generally followed the trajectory of nominal yields,
but have declined by less over 2014. With larger declines in nominal yields than real yields,
estimated breakeven inflation rates - the spread between nominal and inflation-linked bond
yields - have declined (Graph 3). (This calculation is complicated somewhat by the relatively
lower liquidity in indexed bond markets.)
One interpretation of this is that expectations for inflation have fallen considerably. The sharp
decline in oil prices has certainly reduced near-term inflation expectations as most advanced
economies are net oil importers. But this would only account for a decline in inflation
expectations in the short term. A substantial decline in medium-term inflation expectations is
more difficult to explain. Survey-based inflation expectations from market economists and
consumers do not appear to have declined substantially over the same period. It is also
worth noting that the decline in longer-run inflation expectations over the past six months is
not a universal phenomenon - Australian breakeven rates were broadly flat over the second
half of 2014 (and consistent with the RBA's inflation target).
Finally, one potential explanation that I have only briefly discussed above is that yields are
being held down by a shortage of risk-free assets as demand for these assets has
increased.1 I find this explanation of increased demand for such assets in the face of slower
growth in the supply to be the most plausible. But even so, term premia are unusually
compressed and there is little overall compensation for risk.
Australian Government Bond Market
Yields on Australian Government bonds have been affected by these international factors
over recent months as well as some domestic influences. At the shorter end, the February
reduction in the cash rate target and associated repricing of market expectations for future
monetary policy have contributed to a decline in yields. At the longer end, there has been a
tendency for yields to follow developments in global markets. While the strong historical
correlation between yields on long-term Australian and US government bonds has been
evident, the spread between 10-year yields has narrowed considerably, declining from
100 basis points in the middle of last year to be as low as 40 basis points. The net outcome
of these developments has seen yields on Australian 10-year Commonwealth Government
securities (CGS) decline to their lowest level since Federation with an all-time low of 2.28 per
cent being recorded in February (Graph 4).
These declines in CGS yields over recent years - and similar declines in yields on state
government bonds ("semis") - have occurred notwithstanding an increase in the supply of
CGS and semis on issue. But the stock of debt on issue remains considerably less as a
share of GDP than nearly all other jurisdictions (Graph 5).
The vast majority of the post-crisis CGS issuance has been purchased by non-residents
attracted to the Australian Government's AAA credit rating and favourable level of yields
relative to other highly rated sovereign issuers. The six-fold increase in non-residents'
holdings of CGS since late 2007 took non-residents' ownership of the outstanding stock of
CGS to just under 80 per cent in 2010, although this share has declined a little recently
(Graph 6). The recent decline is not because of any net selling, but rather because buying
has not quite kept pace with recent issuance.
The increased foreign holdings of government debt have been reflected in a notable change
in the composition of Australia's foreign liabilities (Graph 7). The stock of net foreign liabilities
has remained steady at around 55 per cent of GDP for the past decade. But over the past
five years, foreign holdings of Australian government debt have risen to around 20 per cent
of GDP, with a broadly offsetting decline in foreign holdings of Australian bank debt as a
share of GDP.
Turning to developments in the semis market, yields on semis have fallen by more than
those on CGS, such that secondary market spreads have fallen to around 30 basis points.
This is around the lowest spread seen since the early 2000s and semi yields are at historical
lows. State governments are able to borrow on average at rates under 3 per cent (Graph 8).
In terms of ownership, since 2007 there has been a marked increase in the share held by
banks in Australia. This is a consequence of banks' desire to hold more high-quality liquid
assets (HQLA) in the aftermath of the global financial crisis and, more recently, the Liquidity
Coverage Ratio (LCR) prudential requirements that came into effect in Australia at the
beginning of 2015.
APRA has determined that the Australian banking system needs to hold around $410 billion
of HQLA in 2015. Of this amount, and based on RBA advice, up to $175 billion could be met
through holding CGS and semis. The Bank's assessment is that larger holdings by Australian
banks could impair liquidity of these securities, undermining the purpose of the LCR. The
introduction of the LCR has proceeded smoothly, but of course APRA and the RBA will
continue to monitor developments in markets to ensure that liquidity conditions remain
appropriate.
The increased demand from banks for semis is having a noticeable impact on the type of
debt securities being issued by the states (Graph 9). In line with the banks' preference for
floating-rate debt - which can be better matched to banks' floating-rate liabilities - the share
of floating-rate semis in recent years has increased. Consequently, the share of floating-rate
notes in the outstanding stock of semis has increased from 2 per cent at the end of 2012 to
around 10 per cent at present. Similarly, the preference of banks for shorter term debt has
led to a decline in the average tenor of semis outstanding.
Regulatory developments
I will finish by discussing the effect of some recent regulatory changes in the local fixed
income market.
One global development that has garnered a large amount of comment of late is the effect of
reduced market-making capacity in fixed income.2 The Bank for International Settlements
(BIS) Committee on the Global Financial System (CGFS), of which I am a member, issued a
report on this topic late last year.3 That report documents the intended effect of regulation in
bringing about this reduction. There is a debate as to whether the reduction has gone too far,
but the fact that market-making activity is lower than it was pre-crisis is a desirable outcome
given liquidity risk was under-priced pre-crisis.
Rather than describing it as a reduction in market-making, I think it is more useful to think of
it as a reduction in the risk-absorption capacity of intermediaries. Their ability to warehouse
portfolio adjustments of asset managers is curtailed. In the past, asset managers were
dealing bilaterally with individual trading desks that each had their own limit. Now these limits
are applied holistically across the trading desks so that selling one part of a portfolio to one
desk will reduce the capacity to sell another part of the portfolio to another desk in the same
institution. Asset managers need to take account of these changes in market dynamics in
thinking about how they adjust their portfolios. Transactions costs are higher and, in
particular, liquidity costs are higher. I am not sure that all market participants have fully
appreciated this yet and are fully cognisant of the impact of the post-crisis changes.
The second development to note is in the asset-backed security space. As many of you
know, as of 30 June this year, the Bank will introduce mandatory reporting requirements for
repo-eligible asset-backed securities (ABS). The Bank continues to work with the industry to
ensure the timely implementation of these requirements. The required information, which
must also be made available to permitted users, will promote greater transparency in the
market, supporting investor confidence in these assets. These requirements will also provide
the Bank with standardised and detailed data on ABS, which are a major part of the collateral
eligible to be used under the CLF.
In preparation for the introduction of these reporting requirements and to facilitate industry
readiness, the reporting system for securitisations was made available for industry testing in
November 2014, with voluntary reporting accepted from 31 December 2014. The Bank is
currently working with a number of institutions undertaking test submissions, with some
institutions expecting to commence regular reporting shortly. The industry is strongly
encouraged to undertake testing early to ensure readiness for the commencement of
mandatory reporting on 30 June 2015.
The third development is the proposed changes to the settlement convention to T+2 for
overthe-counter (OTC) transactions in domestic fixed income securities. The Bank strongly
encouraged this initiative. The current standard of T+3 settlement in the Australian market
compares unfavourably with many other jurisdictions that have already progressed to shorter
settlement cycles for OTC transactions in their domestic fixed income markets. A shorter
settlement cycle will reduce the risks associated with settlement, in particular, counterparty
risk. Market makers in OTC fixed income securities may particularly benefit from the reduced
period of counterparty exposure, as any given trade will count towards internal credit limits
for a shorter period of time. This could boost market turnover and trading capacity for
participants. Further, moving to T+2 is likely to encourage straight-through processing, which
could reduce the risk of an operational issue affecting the settlement of OTC fixed income
securities. Ideally, this would be implemented by the end of 2015.
Finally, a few words on interest rate benchmarks. The RBA, together with ASIC, is working
with the industry through AFMA to develop a robust risk-free interest rate benchmark in the
local market, likely based on overnight indexed swap (OIS) rates. Once this is operational,
this will help engender a movement of products towards referencing a risk-free benchmark
rather than a credit benchmark such as bank bill swap (BBSW) rates.4 We expect to see
progress on this in the coming months.
Conclusion
To conclude, there are a large number of moving parts in fixed income at the moment. A
number of international and domestic factors are having an important influence on Australian
bond markets. The low levels of yields globally and domestically are difficult to explain, most
notably the low level of term premia. The most plausible explanation relates to a shortage of
"risk-free" assets although with term premia so low, it's not clear how risk-free they actually
are.
At the same time as grappling with these developments, investors need to be aware of the
changed market dynamics and factor the higher transactions costs in fixed income, and
particularly the higher cost of liquidity provision, into their decision-making.
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