Review by the Chief Executive Officer
During 2018-19 the AOFM ensured that the government’s expenditure obligations were met at all times and its Budget financing needs were delivered in full and cost effectively without undue risk. The AOFM also managed the Australian Government Securities (AGS) portfolio with a view to promoting market integrity while balancing a range of medium-long term debt portfolio considerations.
Term issuance for 2018-19 was $61 billion; considerably lower than for the previous year ($81 billion) and a direct reflection of improving fiscal outcomes. Issuance was smoothly absorbed into global financial markets during the year, although this was helped by the AOFM retaining sufficient flexibility to make issuance decisions conducive to market conditions at the time.
Much of the AOFM’s engagement with AGS investors focused on explaining the implications of reduced issuance programs, including how this would result in some changes in the issuance pattern without adversely impacting liquidity or support for the futures contracts. In terms of cash portfolio management, the AOFM maintained a strategy similar to past years to ensure that a reasonable contingency was in place at all times to cover forecast payment obligations even if the ability to issue bonds were to have been temporarily impeded.
Elevated US Treasury bonds yields relative to AGS yields carried over from the previous year and this created some pressure on the AGS market because US Treasuries are a key investment alternative to AGS for many investors. Around November, global financial markets began to exhibit heightened levels of volatility, one result of which was a rally in bond markets that started a decline in yields most notably in the US but also throughout Europe, with AGS yields being ‘dragged down’ by other markets.
The backdrop for this market activity derived from a number of factors, monetary policies in the major economic zones again being significant. During the year the US Federal Reserve raised the cash target rate twice (to a mid-point high of 2.375 per cent), with the Bank of Canada (BoC) also moving twice. The European Central Bank (ECB) and Bank of Japan (BoJ) held rates steady throughout, while maintaining respective quantitative easing programs. The Bank of England (BoE) implemented one increase, which at the time looked to be in line with the outlook for the major EU economies.
The difference in economic performance and outlook between most notably the US and other countries had a marked effect on global capital flows during the year with fixed income and equities markets in the US attracting what looks to at times to have been some substantial global reallocations. AGS yields tended to perform relatively well although it became apparent to AOFM via feedback from the banks that the more active offshore investors that had been part of the AGS investor base in previous years had acted on the prospect of higher returns in other markets. These patterns are often difficult to discern because offshore investor decisions are based on a wide range of factors, some of which are not possible to observe, but are dominated by changes to foreign exchange levels, cross currency hedging costs, and movements in bond yields. One thing notable to the AOFM was a gradually increasing concentration of demand over the year around the futures baskets, and the 10-year futures basket in particular. This meant that opportunities to issue bonds of 15-year maturity or longer became more restricted compared with previous years. While not a problem for the AOFM in achieving its issuance strategy for the year, it was yet another reminder that issuance conditions are heavily influenced by global market factors.
Bond yields during the first half of 2018-19 remained relatively stable with market expectations signalling higher monetary policy rates (which as noted above were only delivered by the US Fed, the BoC and the BoE). One dynamic that did appreciably impact markets, particularly in the first half of the year, was the elevated funding rates for investors looking to fund their positions in repo markets (including the Australian repo market). This had the effect of limiting the ability of some investors to hold large positions in AGS. These conditions began to ease toward the end of the year but the AOFM is aware that this is likely to have resulted in a notable constraint to demand for AGS at times throughout the year.
As the second half of 2018-19 unfolded there were several substantial shifts to global financial market sentiment. Ongoing trade tensions between the US and China led to revisions to the economic outlook to both of those economies, with flow-on revisions to other regions. This resulted in a reversal in market views of monetary policy rates (largely from either increase or neutral to a ‘cut’), initiating a strong, consistent rally in bond markets generally. By the end of the financial year, AGS yields had reached historic lows. The spread between yields on ten-year Australian Treasury Bonds and US Treasuries remained negative, with the 30-year spread also turning negative during the year. The tightness of the funding pressures experienced during 2018 eased somewhat during the second half of 2018-19. Whilst lower relative yields and periods of elevated funding costs will have affected demand for AGS, investor diversity across the market tended to support aggregate demand.
During 2018-19, the level of offshore ownership of AGS remained at around 60 per cent. An apparent trend of onshore investor buying being dominated by domestic bank balance sheets that abated toward the end of 2017-18 did not noticeably return during 2018-19. All other things being equal, offshore investors are attracted to the AGS market by strong underlying liquidity relative to other markets (except the US Treasuries market of course, which is the largest and most liquid market). The credit quality of the Australian Government and the transparency and regularity of issuance are also important factors. The AOFM remains aware that should these features persist, the AGS market will continue to exhibit efficiency and resilience, providing the government with good access to financial markets as the need arises. However, 2018-19 was a timely reminder that AGS relies on the support of a large cohort of offshore investors and relative value between AGS and other investment alternatives can weigh on market demand, especially during periods where prices are adjusting to reflect changes in market conditions.
Issuance, market maintenance and portfolio management
The 2018-19 issuance program was undertaken through the familiar combination of regular weekly competitive tenders and several syndications where new bond lines were being established. The program was complemented by regular bond buyback tenders that have also become accepted by the market as a normal part of the AOFM’s operations.
Treasury Bond issuance of $55 billion focused on achieving the AOFM’s portfolio strategy, while supporting the bond futures contracts and market liquidity. The AOFM achieved its strategy of maintaining the duration of the portfolio, which had been incrementally lengthened over the previous six years, in the face of historically low term-premium assessments and during a period of declining yields. This leaves the AOFM with the enhanced range of issuance options it had achieved by lengthening the yield curve to 30 years (and in doing so broadening the diversity of the investor base). The AGS market internationally remains fully comparable to many other sovereign markets that would be considered as ‘peer’ markets. This leaves Australia well-placed in terms of access to global financial markets as and when this becomes necessary.
Treasury Indexed Bond issuance for the year totalled $5.9 billion, of which $2.2 billion was conducted via tender and $3.75 billion was by syndication for a new 30-year line. In conjunction with the syndication, around $2.1 billion of the August 2020 Treasury Indexed Bond line was repurchased to improve the efficiency of this market. A further $1 billion of the August 2020 line was repurchased in a separate later operation.
In addition to the repurchase of Treasury Indexed Bonds the AOFM also repurchased $23.1 billion of Treasury Bonds ahead of maturity (almost the same as the previous year), of which $14.7 billion were acquired through buyback tenders, $2.0 billion were bought back in conjunction with syndication and $6.3 billion were purchased from the RBA.
The financial market outlook has been described by some market participants as amongst the most uncertain since shortly after the GFC. It continues to be dominated by speculation about the potential for further appreciable slowing in global economic growth and inflation prospects, not the least being the risks to trade flows arising from tension between the US and China and for the possibility of trade tensions extending to other major trading bloc relationships (including Europe). The recent monetary policy easing with rate cuts by the US Federal Reserve and the recommencement of QE by the ECB will impact the relative performance between sovereign bond markets and has the additional potential to create more uncertainty in foreign exchange markets. This will be at a time when policy rates are already at historically low levels and central bank balance sheets are at elevated levels as a result of various quantitative easing programs.
Add to this the continued risk of market disruption arising from geopolitical disputes and uncertainty as to when and how the UK will disengage from current arrangements with the EU, the global outlook is confused at best. These, amongst other factors, remain relevant to the AOFM’s deliberations although the risk outlook for issuance remains appreciably lower given the forecast for programs around half of what they were just three years ago. Depending on the cause, a sudden and steep deterioration in global market conditions could become challenging for AOFM issuance although there is considerable operational flexibility, including the holding of substantial cash reserves, to deal with a wide range of global market circumstances.
The AOFM remains focused on portfolio management objectives that will support a diversified investor base and a continuing outlook for declining issuance (in line with improving fiscal forecasts), but little expected change in the overall size of the debt portfolio. A continuing need to communicate clearly regarding carefully considered issuance plans that will meet the test of the changing fiscal and global market circumstances remains at the forefront of AOFM awareness in how to deal with financial markets.
During the year the AOFM was given the responsibility to implement the government’s new Australian Business Securitisation Fund. This will involve careful investment of a growing pool of funds (up to $2 billion over three years) in wholesale market operations in support of lenders to small and medium sized business, many of which find access to unsecured business lending a challenging proposition. Considerable work had begun by the start of 2019-20 to implement this program. However, a lot remains to be done to ensure appropriate arrangements are in place to assess the proposals for support from lenders that will form a key part of the program, together with devising meaningful ways for the AOFM to promote development of this sector of the domestic financial market.
Chief Executive Officer