AOFM's thoughts on sovereign debt management | Perth
Presentation to CEDA
Rob Nicholl, CEO
As the AOFM sits as an interface between the Commonwealth Government and financial markets, I was asked to offer some observations on: sovereign debt management; the investor base; and a glimpse into some risks we see to the outlook.
I note that the theme for today is trust. This plays a central role in how the AOFM judges success – we are trusted to make decisions that, from a taxpayer perspective, involve staggeringly large dollar amounts. Financial markets also develop trust in issuers, like the AOFM, relying heavily on predictability in behaviour and transparency in communication. Failure in this would likely result in higher borrowing costs.
Since the GFC, policy makers have focused on below trend economic growth and adjusting regulatory settings for the financial sector. Should another major global market dislocation occur, they would like to avoid a repeat of the GFC experience. “Unchartered territory” and “unprecedented circumstances” have been common comments in the last 10 years. It’s worth noting that about 20 years ago under different circumstances, but for similar reasons, the Japanese first used ‘extraordinary’ monetary policy or ‘QE’ (euphemisms for flooding financial markets with cash). Those settings remain in place.
Australia escaped the worst of the GFC but there has been renewed attention to government borrowing; a debate in which the benefits of an efficient bond market tend to be overshadowed by a simplistic focus on the costs, which are more widely recognisable. However, the market plays a number of important roles, including facilitation of pricing state government and corporate borrowing.
Prior to the GFC our bond market had been maintained by simply rolling over outstanding debt, although it was considered small and often illiquid.
At the time of the GFC, Budget forecasts were for a relatively short-lived debt financing need. However, successive revisions to the fiscal outlook gave cause to plan an extended borrowing profile. This was on the basis that as total debt outstanding increases, borrowing over a longer period reduces re-financing and interest rate risks. Extending the profile from 12 to 30 years therefore became an objective.
One result of this is that gross issuance over the next five years will be around $100 billion lower than it would otherwise have been, materially reducing re-financing risk and insulating a good part of the debt portfolio from future interest rate volatility.
Another outcome is greater diversity of the investor base, which brings me to the second part of what I will cover.
The term ‘flight to quality’ reflects reducing risk exposure in return for lower yields. This has been important during periods of market stress. With a triple‑A credit rating; a liquid currency; and a liquid bond market – Australia looks attractive in such times.
Central bank participation has also been important, the number increasing from around a dozen to just over 50. They put capital preservation ahead of high returns and typically hold investment mandates for long periods, making them a stable core to the offshore investor base. Other offshore investor types include fund managers, sovereign wealth funds, hedge funds and life insurance companies. These investors exhibit a range of behaviour responding differently to yield and cross-currency adjustments.
Another offshore dimension is geography, with Europe and Asia featuring particularly heavily and Japan, the UK and the Americas also being important.
Apart from attracting some of the largest fund managers in the world, we have also seen strong global hedge fund participation. Although often referred to as ‘hot’ or ‘fast’ money, we see them as a productive investor category because their buying and selling helps market liquidity. However, they tend to rely on short-term finance to fund their positions, which creates vulnerability.
Extending the borrowing profile attracted increasing interest from pension and insurance funds. They aim to cover long-term liabilities, which also often makes them look stable, like central banks.
Japanese life insurers also increased the strength of their presence. ‘Mrs Watanabe’ – the archetypical Japanese household investor is a part of that cohort – canny, informed and ruthlessly returns focused. They generally appear to act in unison, which adds an interesting dynamic to their presence.
Within Australia fund managers have dominated but the large domestic banks have been notably active over recent years. APRA has designated Commonwealth and state government bonds as eligible for defensive asset purposes, with banks now holding over half of all state government bonds and just under a fifth of Commonwealth debt as a result.
In summary, the investor base is diverse because the size of the Australian market now offers confidence that participation can justify the effort required to understand it. It is also widely acknowledged for good liquidity, which is important because investors don’t want to be moving prices against themselves while executing buy or sell trades. Lastly, an extended borrowing profile offers a wider range of investment options while for us opening more issuance choice. Investor diversity is desirable because it tends to reduce the likelihood they will be reacting at the same time in the same way. Looking back it has been a challenging and engaging period and one which at times has given me cause to walk through some pretty interesting front doors.
But diversity is one thing, stability another and if anything is constant in financial markets it is change. This brings me to some high-level risks to the outlook.
It is easy to be distracted by rate and currency moves; an unrelenting stream of updates, chit-chat; calamities, predictions and opinions. Those of you familiar with the Die Hard movies starring Bruce Willis as John McClane will get the picture.
But we’re not that sensitive to daily market volatility, our focus more on the potential for: (1) a sharp increase in the need to borrow; (2) a temporary but sudden inability to issue; and (3) shifts in investor preference away from Australia.
The first is not something I will comment on today. As to the second, we hold contingency cash reserves to cover such an event because it could be triggered suddenly and arrive with little warning. However, global macro and capital flow dynamics are of particular interest, and of these I will leave you with a few examples.
About 18 months ago and for the first time since the GFC an increasing synchronisation of global economic growth appeared, with a gradual reversal of widespread ‘QE’ settings an expected outcome. In turn, speculation intensified as to how interest rates across countries would rise. Differences in the speed at which these adjustments occurred would also be relevant, but how markets reacted to unwinding ‘QE’ was always going to be difficult to predict.
In any event, the US story has been contrasted by slowing growth in China and across Europe, with conditions remaining unchanged in Japan. As a result, monetary policies actually began to diverge and changes in the pace and direction of interest rates opened up most notably between the US and elsewhere, contributing to appreciable moves in cross-currency levels. In this regard, a weaker $AUD can induce investors to top-up allocations (like central banks which don’t hedge currency risk), while triggering selling by others seeing the need to protect profit or stop losses.
Where market expectations are for relatively higher US interest rates compared to other countries, the cost of hedging $USD denominated assets back into another currency rises, with a consequence that hedging costs of $AUD assets back into another currency would be comparably lower. On its own this suggests increasing demand for Australian bonds relative to US Treasuries. But yields for US Treasuries have been rising, and because investors look at the overall return we are tracking this after taking hedging costs into account. It shows that widening interest rate differences (in favour of US Treasuries) have been offsetting increasing $USD hedging costs and this we believe is one reason some offshore investors have been allocating away from Australian Government Bonds into US Treasuries. In particular it appears that this is something Japanese investors have reacted to.
At the same time short term money markets have changed – led by the US, in which funding costs have increased. In Australia the supply of short-term funding has also decreased, compounding the cost rise. In response, some investors (such as hedge funds) have recently indicated the potential for this to constrain their participation in our market.
When it comes to China, Australians tend to focus on its outright economic performance because of its link to the fortunes of our export sector. But there are other dimensions to consider. For example, as the composition of China’s GDP growth moves from an exports focus to higher levels of consumption, its accumulation of foreign exchange reserves is slowing. If predictions for massive increases in US Treasury issuance eventuate, this is would be at a time when one of the largest destinations for US Treasuries has a diminished capacity to continue in that role. Without substitute demand this will push US yields even higher, further widening the difference with Australia.
With a backdrop of slowing major European economies, including the UK, expectations of a return to widespread ‘QE’ are now also emerging. As I noted earlier these dynamics are not a new story for Japan, which begs the grim question as to whether the GFC impact globally had actually run full course a long time ago. This could mean we are now in a world in which fiscal and/or monetary policy are more consistently relied on to promote investment and in turn economic growth; or at worst to avoid another global recession.
Greater risk uncertainty tends to make sovereign bonds look attractive relative to other asset classes, but what I have just described portrays circumstances in which it could be harder and more costly for us to issue in the next cycle should that be necessary. Then again, I could be wrong – maybe John McClane jumps to an adjacent skyscraper just as his tormentors blow it all up from beneath him. Global markets are a dynamic arena with virtually unlimited scenarios to contemplate. But there is good reason to be prepared for as many as possible.