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Weekly Highlights

In a reversal of performance from the previous week the major banks (and BHP) led domestic equity markets higher last week (up 208 points of 4.28%) while Australian Government Bonds were weaker. The long end of the bond curve (5+ years) widened by ~0.15%, which may not sound like a lot but in the context of the low interest rate environment this equates to nearly $1.50 in capital for a 10-Year Bond. The performance of the banks is primarily being driven by uncertainty about the bank’s asset quality if the residential mortgage market deteriorates. This debate is ongoing but the most recent results suggest that asset quality remains sound with only patches of deterioration in mining regions.

 

The more pressing story last week was the Commonwealth Bank following its peers and raising interest rates on business loans by up to 0.21%. This action demonstrates the power of the major banks to act independently of the RBA to offset the increased cost of funding. In an environment where competition was strong this would lead to an adjustment in market share but the truth is the major banks still dominate lending in Australia and they dictate the cost of lending themselves. Therefore, any change in capital or funding requirements which effects their return on equity will be passed on to consumers. This is one of the reasons why the banks have such a strong long-term outlook.

 

And while we are on capital, the landscape continues to change for the banks with the Bank for International Settlements (BIS) last week releasing a consultative report on measuring what is known as “operational risk”. Under the proposed changes to global regulation banks will lose their ability to “self-measure” capital requirements for operational risks. This change is likely to be a long way down the track and still needs to be adopted and implemented by APRA. There are far too many uncertainties surrounding this change to suggest it will be punitive for the banks but the regulator (BIS) commented that “modelling of operational risk for regulatory capital purposes is unduly complex and …. resulted in excessive variability in risk-weighted assets and insufficient levels of capital for some banks”. This is a complex area for the global banking industry and hence the regulatory will conduct an intensive impact study followed by industry feedback before declaring the details of the new standardised model for operational risk. Bank operations are held back by systemic issues that are embedded in settlement, clearing, and payment systems. It is also part of the reason why the banks have been investing in “blockchain technologies”. Last week a US based company called R3 announced it had successfully completed a trial of trading fixed income assets between 40 of the world’s largest banks (including CBA, NAB and WBC – click here for link). The whole test was designed to evaluate the strengths and weaknesses of the technology by running “smart contracts” that were programmed to facilitate issuance, secondary trading and redemption of commercial paper (a short-term fixed income security) issued by corporations to raise funding.

 

In more domestic news our Senior Banks Analyst has been watching the performance of the listed bank hybrid market since PERLS VIII was announced. As expected the securities with an expected call date of less than three years have outperformed the longer dated hybrids. For more information click here.

 

Click below for Interactive Charts

Chart 1: Bloomberg AUSBond Composite Index (Monthly)

Chart 2: Bonds vs Equities 2014/15/16 (Monthly)

 

Interest Rates

It was a busy week for interest rates traders last week with US non-farm payroll (employment) data and the Reserve Bank board meeting. The stronger than expected US payrolls (242 thousand new jobs in February) saw bond yields rise in the US and credit spreads narrow but the overall jobless rate remained steady at 4.9%. Overall markets decided that on balance the result was good and opened up the possibility of the Fed might table an interest rate rise mid-year. As a result, US interest rate markets were weaker. In Australia the RBA continued to sit on its hands leaving rates unchanged at its meeting last week. They continue to believe that monetary policy is accommodative already but there is still room to lower rates if necessary. However, the rise in the Australian Dollar and repricing of bank lending will put increasing pressure on the RBA to further lower interest rates to support the services industry which has been at the forefront of stabilising the economy.

 

In February 2015, the 10-year bond yield hit an all-time low of 2.27% before lifting to highs near 3.15% on 11 June 2015. In early November 2015 there was a progressive increase in yield from ~2.60% to a high of 2.99%. Since mid-December the flight to quality has meant the 10-year yield has given back the changes in Q4 2015 and on 1 March 2016 hit a 6 month low of 2.35%. However, in the past week we have seen a sharp bounce back up to 2.60%. The 3-year bond has followed a similar pattern and broke out of its recent yield range (1.90 – 2.1%) in November/December 2015 reaching a high of 2.18% on 7 December 2015. It retraced back to a short term low of 1.70% but then jumped back up to 1.94% in the past week. On 4 March 2016, the ASX 30 Day Interbank Cash Rate Futures March 2016 contract was trading at 98.025 indicating a 12% expectation of an interest rate decrease to 1.75% at the next RBA Board meeting (up from 7% previous week).

 

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