Click here to access the BondAdviser Ratesheet as at 10 May 2016
Concerns over a downgrade to Australia’s coveted ‘AAA’ credit rating to ‘AA+’ is not new. The Australian bond market has been concerned of this eventuality for many years. All sides of politics share the blame for this, as do the Australian electorate for encouraging short term economic policies.
What has saved Australia’s ‘AAA’ rating has been the resource sectors boost to national income and successive federal budgets doing just enough to convince the rating agencies that Australia will return to surplus during the next 5-10 years.
Unfortunately, Moody’s Investor Services last week indicated that their patience is starting to wear thin with analyst Marie Diron telling the Australian Financial Review that “We’ve seen, as the election approaches, a narrowing of options. Some measures on the revenue side, like tax increases, the broadening of the tax base, now seem no longer to be considered. The increasingly narrow set of options means the objective of balancing the budget seems very challenging.”
If Australia were to lose the ‘AAA’ credit rating not only could the Australian federal and State governments expect to see an increase in funding costs, so too could the Australian banking system. The State governments and the four major Australian banks have a degree of inter-dependency on the Australian sovereign credit rating.
The four majors have a stand-alone credit profile (SACP) of ‘A’. The rating agencies then apply a further two notches uplift to the SACP due to potential extraordinary government support (in the unlikely event it is required) to boost the senior credit rating to ‘AA-’.
If Australia were to receive a downgrade to ‘AA’ on the foreign currency rating, the banks may initially escape a downgrade if the local currency credit rating were to remain at ‘AAA’. However, the rating agencies could decide to downgrade the banks senior credit rating to ‘A+’ for a multitude of other reasons due to;
- Concerns over economic imbalances relating to the banking sector’s reliance upon foreign funding;
- Increasing credit risks surrounding the housing market, i.e. bad and doubtful debts rising significantly if house prices fall significantly (don’t rule this out if the bank’s start to seriously ration credit); or
- Lower likelihood of sovereign support if the total loss absorbing capacity debate within Australia follows the Canadian route.
A downgrade to the banks could cause a further increase in funding costs, which in turn would likely be passed on to borrowers as we have already seen.
If this happens, Australia will have less capacity to weather the next global or domestic financial crisis.
Compared to 2008 Australia may not this time have a AAA rating, no budget surplus to cushion any economic blow and a harder task to secure the funding that Australian households need at a time when they have become more leveraged to inflated house prices.
Click below for Interactive Charts
Minutes into the RBA’s decision to maintain the cash rate at 2.00% are set to be realeased tomorrow. However, given the March employment numbers from last week (26.1k jobs added with unemployment rate dropping from 5.8% to 5.7%) it is unlikely the RBA will cut rates further in the short term and we expect tomorrow’s paper to be consistent with this rationale. The unemployment rate peaked at 6.3% last year and continuing signs of improvement in the job markets will most likely result in reluctance from the RBA to move from its position in May. Additionally, the Federal budget is scheduled to be released on the same day as the RBA’s May meeting and further reiterates the expected decision to Hold.
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 meant the 10-year yield gave back the changes in Q4 2015 and on 1 March 2016 hit a 6 month low of 2.35%. In the past few months we have seen a short term bounce back up but the yield is now consolidating back down around 2.55%. The 3-year bond has followed a similar pattern and broke out of its recent yield range (1.90 – 2.10%) 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 since then it has wildly jumped up and down and currently sits around 1.97%. On 15 April 2016, the ASX 30 Day Interbank Cash Rate Futures April 2016 contract was trading at 98.035 indicating a 16% expectation of an interest rate decrease to 1.75% at the next RBA Board meeting (down significantly from 42% the week prior).