System shock, system growth
While there is no clear consensus on the long-term outcome of the recent Bank of Japan announcement on yield curve control, some market sources believe it could have a profound impact on the demand for international securities that have benefited from a substantial Japanese bid. If this view is correct, it will lead to a number of questions about the size and function of the Australian dollar market.
Laurence Davison Head of Content KANGANEWS
It must be stated upfront that what follows is largely based on a worst-case – or at least a worse-case – scenario for the Bank of Japan (BOJ) policy outlook and the consequences for Japanese investor behaviour. Plenty of market users are confident that the BOJ’s policy stance will not change enough to be truly significant, that the change will happen so gradually that its impact will largely be absorbed by the market, or that the size of the Japanese investment pool will make offshore allocations just as relevant even in a higher domestic yield environment.
I am not qualified to predict what the outcome will be – but I am also not qualified to rule out negative consequences. The downside view holds that even a relatively small shift upward in Japanese long-term yield – that would not even have to be accompanied by a normalisation of the front-end cash rate – would re-establish a term premium in the yen market and encourage local investors that have been forced offshore to find return to repatriate some of their assets.
Note that this would not have to mean a ‘full’ repatriation. The idea of Japanese investors, as a group, only holding yen-denominated assets is absurd on its face, based on a basic understanding of the value of diversification and the size of the Japanese investment pool relative to the range of options available domestically.
On the other hand, it would not require every dollar, pound or euro allocation that originates with a Japanese investor to return to the homeland to have a fairly seismic impact on global markets. Australia would be among the more exposed jurisdictions, given the historical importance of the Japanese bid.
Analyst estimates of Japanese holdings of Australian Commonwealth government bonds typically range from 7 per cent to 15 per cent of outstandings – almost certainly more than the equivalent figure of roughly 5 per cent of the US Treasury market. It is not just the sovereign sector than benefits from the Japanese bid, either. Securitisation issuers, to take one example, have enjoyed substantial investment in senior transaction tranches in particular.
In 2020, the Australian Office of Financial Management suggested – based on BOJ data – that Japanese holdings of Australian assets represented 7 per cent of their overall fixed income allocation. “Japan has been the single largest investor in Australian fixed income by country, with a large pool of savings including pension funds and life insurance assets,” the sovereign debt management agency noted. “Persistent low yields in Japanese government bonds over a long period have led Japanese investors to seek higher returns and diversity outside of Japan, including Australia.”
Ultimately, it is hard to guess how significant the impact would be should those persistent low yields improve. Perhaps the safest conclusion to draw is that there would almost certainly be some consequences for long-end liquidity and pricing in the Australian dollar market, and a non-zero possibility that these consequences would be significant. The question would then likely become one of how well set up the Australian dollar market is to absorb the impact.
“It would not require every dollar, pound or euro allocation that originates with a Japanese investor to return to the homeland to have a fairly seismic impact on global markets. Australia would be among the more exposed markets, given the historical importance of the Japanese bid.”
HOW BIG IS THE MARKET?
Answering this is difficult, because prominent positive and negative inputs are in play. There has clearly been system growth in the Australian dollar rates and credit sectors – as can be seen from deal outcomes and commentary in the local semi-government and bank sectors.
One of the recurring themes of KangaNews’s recently published Australasian high-grade yearbook was the exponential increase in turnover experienced by Australia’s largest state government borrowers. Bigger programmes have attracted more buyers with a range of motivations and relative-value views, leading to a more positive trading environment. Elsewhere in this publication, you can read about how better secondary liquidity is allowing investors to exploit relative-value opportunities that historically might have looked good on screen but could not be executed in size.
A similar story has emerged in the bank sector. Australia’s big-four banks have regularly printed domestic senior deals of A$4-5 billion (US$2.6-3.2 billion) or even more, while the resilience of the bid for tier-two securities has surprised even local issuers.
Meanwhile, deal flow in August demonstrates once again that there is appetite in Australian dollars for diverse, international financial sector credit. Singaporean banks active this year are finding it possible to execute transaction sizes of A$1-1.5 billion, having started their local issuance programmes just a few years ago with prints typically in the A$500 million area.
There is clearly more demand for Australian dollar bonds, and to at least some extent it is coming from diverse sources. The international flow ties in with a growing investor base for Australian dollar product in Asia beyond Japan, while the higher yield, “bonds are back” narrative is accompanied by greater allocations to the sector from domestic superannuation funds.
Even if Japanese participation wanes quite significantly, there are grounds to believe the impact will be either minimal or no more than a marginal repricing rather than a genuine shortage of capital. The chances of this positive outcome would only grow if – as everyone appears to agree – the BOJ takes a slow and steady approach to the prospective unwind of yield curve control.
However, there are also reasons to believe market growth may be somewhat narrower than the most positive interpretation of events implies. Real-money investors and some dealers have noted that by far the biggest source of incremental investment and turnover in semi-government bonds has been bank books, motivated by a need to bulk up high-quality liquid asset (HQLA) holdings after the expiry of the committed liquidity facility and term funding facility. Scale of turnover does not have a linear impact on actual liquidity, some investors say, due to the narrow nature of market growth.
Elsewhere, the travails of the Australian dollar corporate bond market suggest everything is not yet rosy in the credit world. Where bank deal sizes have grown, corporates have stagnated. The Asian bid is important in the corporate space, but seemingly largely as a source of early momentum to persuade recalcitrant domestic accounts to proffer bids.
The two key questions here are how big the Australian dollar market would really be without the crutch of bank balance sheets, and whether a narrower market really matters if those buyers are perennially active. The first question is hard to answer: tier-two deal outcomes suggest there can be plenty of demand for transactions that asset-liability management (ALM) books do not typically support, while the corporate market suggests the nonbank bid is still thin, at least at times.
The second question is perhaps unanswerable. Positive information emerges on occasion, for instance the suggestion that a substantial offshore bid for Australian securitisation is lurking, denied the chance to participate by a bank bid that keeps pricing just inside where relative value would open the taps. But it is hard to know for sure.
Perhaps the evolution of the Japanese bid will provide some answers, especially given its historic affinity with the long end. ALM books are not historically big buyers of long-dated securities, so how this part of the curve fares should the Japanese bid ease will be an important sign of how broad and deep the market is without the bank bid.
“The retreat of supernormal liquidity should enhance the value of real-money pools. Australia, with its vast and ever-growing supply of superannuation savings, certainly has one of these. Its capital market should, at face value, be increasingly important to global borrowers.”
This may be a question of critical mass. There is no doubt that the Australian institutional funds pool is deep and only getting deeper, albeit its allocation to fixed income and credit remains puny when compared with global norms. Bank books will continue to have a natural bid for strong credit and for HQLAs. And, despite economic headwinds, it is hard to imagine the Asian funds management universe not continuing to grow and to seek diversification in markets like Australia.
Global funders should abhor a vacuum – in other words, where there is one, capital issuers should come. In this way, even a receding Japanese bid could be viewed as just one symptom of a wider trend that, in its entirety, should benefit Australia. The retreat of supernormal liquidity should enhance the value of real-money pools. Australia, with its vast and ever-growing supply of superannuation savings, certainly has one of these. Its capital market should, at face value, be increasingly important to international bond issuers.
The corporate market shows, however, that this critical mass is not yet there in such a way as to make the Australian market a reliable source of funds for all types of issuers. The risk factor is one that is playing out in New Zealand: no shortage of investment funds, but an undersupplied local capital market that risks seeing those funds reallocated to global options before they can be used as the foundations on which to build a more consistent domestic pipeline.
It has often been said that it makes no fundamental sense for Australian borrowers to issue in international capital markets while Australian funds are also being directed to the same offshore jurisdictions. The next phase of global liquidity trends may reveal whether the Australian capital market has enough gravity to draw in borrowers before its liquidity pool dissipates.