Australian Financial Review Tuesday 25 May 2021

‘Projected rise in bond rate to 3 3/4 per cent on eve of loan council,’’ ran the front-page headline of the first ever edition of The Australian Financial Review, on August 16, 1951.

That week the federal Treasury’s Loan Council was preparing to float its 13th loan since the end of World War II. The editor of the newly created weekly publication, JC ‘‘Jack’’ Horsfall, speculated the rate it offered would have to go up to lure banks and life assurance companies to invest.

‘‘By hook or by crook the government intends to get money for public works,’’ the front-page article said. Sources would neither confirm nor deny the potential for a rate rise.

In the early days of the Financial Review, commentary on the bond market was a regular on the front page. Since then the path of the sovereign’s borrowing cost-tracked the fortunes of a young nation as it fought wars, inflation, recessions and the threat it could descend into a third-rate economy.

The first edition Financial Review’s speculation was on the money. The Loan Council upped the rate from 3 1/8 to 3 3/4 per cent. But still the £40 million offer failed, coming up £7 million short.

‘‘The money market is befogged,’’ wrote the Financial Review six weeks later as the loan failure was covered in detail.

The post-war era was an uncertain time for Australian finance. Many of the nation’s savers had been guided by patriotic fervour to enter the investment markets, subscribing to War Savings Certificates – government bonds that returned £1 for each 16 shilling investment, or about 2.85 per cent a year.

But in the years that followed, the will to invest for the nation faded, replaced by anxiety over Australia’s large war debts, the threat of inflation and declining wool prices – all pointing to a rising bond rate.

In May 1952, after another poor loan float, prime minister Robert Menzies headed to Washington to negotiate a highly conditional $US50 million loan from the World Bank.

Foreign debt was nothing new to Australia. London’s burgeoning banking system funded Australia’s public works in the second half of the 19th century through the issue of Colonial Consols.

By the turn of the century, as Australia became a federation, its budget revenues matched its outlays. The nation’s first decade was therefore one free of debt.

With the outbreak of war in 1915, the Commonwealth would need to borrow, resulting in its first ever bond. Australia’s debt as a percentage of GDP rose from 2.2 per cent to 50 per cent, with a third of it financed by loans from London.

World War II took an even greater toll on public finances, as debt to GDP tripled from 40 to 120 per cent. But by that time there were sufficient local savings to shift its financing requirement away from foreign lenders. After the war, patriotism waned, but the public’s obsession with the bond rate remained.

‘‘The investment market is obsessed with immediate technical questions, the scarcity of funds, the future of interest rates and the prospective bearing on equity yields,’’ wrote the Financial Review on April 10, 1952, as then treasurer Arthur Fadden dismissed talk of a pending depression as ‘‘completely misplaced’’.

A period of economic prosperity, tough budgets, and low rates and inflation gradually eroded the war debt, with the ratio of debt to GDP down to just 8 per cent by 1976.

The 1970s was a decade of oil shocks and rampant inflation that decimated savings and scorched bond investors. The 10-year rate began the decade at a modest 6 per cent; by December 31, 1979, it was above 10 per cent.

By 1982, it reached 16 per cent. That was the moment when today’s bond market veterans took their first jobs on the money market desks. They wouldn’t have known it at the time, but it was the dawn of the multi-decade bull run that would lead inflation and bond rates on a downward trend.

On June 13, 1982, the 10-year bond rate was perched at its historic peak of 16.4 per cent. There was little trading of government bonds, which were placed to a captive buyer base of heavily regulated banks and insurance companies that held a large portion of their assets in the form of government debt.

The 1980s was a decade of immense change in Australian finance in which the Australian dollar was floated, the Reserve Bank took greater control of interest rates, and in 1986 deregulation brought foreign banks into the local market.

The year 1986 was remembered for another reason. On May 14, treasurer Paul Keating branded the economy a ‘‘banana republic’’ on Sydney’s Radio 2GB as commodity prices and the Australian dollar plunged. But the Financial Review commented on the day that the market reacted wrongly. Keating was demanding something be done on fiscal policy.

‘‘Mr Keating gave the foreign exchange market a message that it should have been pleased to hear – but in return the market belted him over the head with it,’’ wrote then economics editor (and current editor-in-chief) Michael Stutchbury.

Later that year, Standard & Poor’s stripped Australia of its AAA rating, an act that would shape the political and public attitude towards Australia’s public finance to this day.

In late 1990, the data confirmed the largest quarterly contraction of the economy since 1975. It was the recession Keating famously said ‘‘we had to have’’.

‘‘Faced with the political burden of the final confirmation that the economy had entered its first policy-induced recession since 1961, Mr Keating made the best of a bad set of figures by saying the recession was necessary, was not as damaging as in 1982, and may have already passed,’’ the Financial Review reported on Friday, November 30, 1990.

As treasurer John Kerin prepared to hand down the federal budget in August 1991, the Financial Review told its readers that all eyes were on the 10-year rate. This was the market’s barometer of confidence that the government’s budgetary discipline and the central bank’s resolve could keep inflation in check.

‘‘But, unlike the 1980s, it will not be the young foreign exchange screen jockeys in their mid-20s John Kerin hopes to please,’’ wrote Stutchbury on the eve of the budget. ‘‘Instead, it will be the money markets – and particularly the more mature bond market traders in their mid-30s – the new treasurer will hope to woo.’’

Initially, bond markets were appeased. The 10-year rate fell below 10 per cent and on June 5, 1992, the Financial Review noted the yield on the October 2002 benchmark bond had broken 9 per cent.

‘‘Slow growth, low inflation push interest rates down,’’ ran the tagline.

The rate slid to 6.4 per cent before Australian bonds were brutally sold off in the 1994 crash, spiking back up to 10 per cent as traders doubted the resolve of central banks and governments to contain inflation.

The RBA jacked rates up to 275 basis points in the second half of 1994, and by early 1995 long-term bond rates started to fall, a slide that would continue virtually uninterrupted to the present day.

In March 1996, the Liberal Party came to power, with prime minister John Howard and Treasurer Peter Costello intent on demonstrating their credentials as prudent economic managers by paying down Australia’s debts. A key to achieving this was a further $60 billion of public asset sales, and spending cuts that whittled away the government’s gross debt.

Costello also cut a deal with the Reserve Bank, agreeing to institute an inflation target of between 2 and 3 per cent.

‘‘In return the Reserve Bank’s new governor . . . will support the government’s fiscal and employment objectives,’’ the Financial Review reported on August 12, 1996.

Ironically, the public sharemarket floats of Telstra, Commonwealth Bank and Qantas helped to foster a cult of equities, as the percentage of adult investors in the sharemarket rose from 10 to 25 per cent.

Australia’s economic fortunes were on the ascent, and on Monday, February 17, 2003, news came from New York that Australia had regained its AAA rating. The nation had rejoined the small club of elite gilt-edged borrowers as it cut the debt to GDP ratio from 20 per cent to 3 per cent.

But as that upgrade was delivered, Costello was contemplating dismantling the bond market altogether as it earmarked proceeds from a Telstra share sale to retire the remaining sovereign debt.

The Reserve Bank’s then head of domestic operations, Phil Lowe, chaired a discussion on what could replace the bond market if the nation had no debt to repay.

But the plan to close it down was successfully contested by bond traders who argued the day would come when the nation would need its government debt market.

‘‘Financial markets were satisfied by the federal treasurer’s commitment to maintain a liquid and efficient Commonwealth bond market, an outcome that seemed unlikely last October when Mr Costello declared his desire to wipe out the bond market,’’ the Financial Review’s Phil Baker wrote after the May 2003 budget.

It was the right call. By the time Kevin Rudd was sworn in as prime minister on December 3, 2007, the seeds of destruction that would lead to the Lehman Brothers collapse had long since been sown. When it fell, the 10-year rate plunged from 6.5 per cent to below 4 per cent in January 2009, as the Reserve Bank slashed the cash rate from 7.5 per cent to 3 per cent.

By February 2009, the Rudd government had announced $90 billion of stimulus spending that would require the government to lift bond issuance to full pace.

The AAA rating would prove invaluable but it would have to be rented, at great risk, to the nation’s banks and state governments as funding markets seized up. Australia’s banks and top credit rating emerged intact.

Few could claim the same, and amid a shortage of AAA-rated debt, the world’s largest savers, central banks and sovereign wealth funds began buying up Australian bonds. Europe’s sovereign debt crisis and a downgrade of US debt further enhanced the appeal of Australian bonds. By Monday, June 4, 2012, foreign investors held three-quarters of Australian government debt.

That morning, following weak jobs numbers from the US, Australia’s 10-year bond rate fell to 2.80 per cent, the lowest since the four shillings of interest the Commonwealth paid to finance the war.

But rates could and would go much lower. With governments reluctant to borrow, the heavy lifting fell to central banks that, having dropped rates to zero, resorted to unconventional policies to lift growth.

The Reserve Bank, under the steady guidance of Glenn Stevens, remained one of the few major central banks that was able to remain conventional, avoiding a quantitative easing program in which it bought government bonds, crossing the blurred line on central bank independence.

But Stevens’ final act was to cut the cash rate to a historic low of 1.5 per cent in August 2016. His successor, Phil Lowe, took charge of the RBA during what proved to be a turbulent time for global politics. Donald Trump’s shock US presidential election win ushered in what bond traders thought was an age of higher inflation.

Lowe, having refrained from moving interest rates throughout his entire term, eventually acted, cutting the cash rate twice in 2019. That year, bond rates embarked on their ‘‘greatest ever rally’’ as Australia’s 10-year rate breached 1 per cent.

As the zero bound approached, Lowe had to contemplate whether he would have to enact quantitative easing.

But the Reserve Bank would be forced into buying bonds far sooner than Lowe could ever have imagined. As the COVID-19 outbreak locked economies down, the usually reliable bond market buckled.

In a desperate effort to raise cash, super funds rushed to liquidate their government bonds while global hedge funds were squeezed out of highly leveraged trades. That forced Australian bond rates to spike at a time they should have been falling.

‘‘Every alarm was going off and it was difficult to quickly grasp the severity of what has happening,’’ Rob Nicholl, the head of the Australian Office of Financial Management (AOFM), the government’s debt agency, told the Financial Review. In a historic Thursday board meeting on March 19, 2020, Lowe cut the cash rate and committed to buy bonds to stabilise markets.

Treasurer Josh Frydenberg announced an unprecedented $130 billion JobKeeper program once assured that global fixed income investors would finance the plan. The mammoth task of raising the funds fell to the AOFM, which rapidly sold $90 billion in the three months to June 30, 2020 – more than it had raised in the previous 12 months.

It found willing buyers as Australian long-term bond rates yielded higher rates than other AAA-rated sovereigns, even though its finances were in better order.

Record bond raisings followed as the AOFM sold the near $230 billion of bonds required to fund a post-war record deficit.

‘‘We’ve got this covered’’, proclaimed Prime Minister Scott Morrison on May 13, 2020, after a record $19 billion raising.

With the prospect of a years-long recession and sustained deflation, bond rates drifted toward zero. Australia’s 10-year bond market hit an all-time low of 0.72 per cent on October 16, 2020.

It seems increasingly likely the date marked the end of a four-decade bull run for the bond market, as long-term rates fell from a peak of 16.4 per cent to a third of 1 per cent, sustaining a boom in shares and property, and marking a period of prosperity for the nation.

While the Australian 10-year bond rate reached a record low, ironically it was too high compared to other developed nations. The Reserve Bank faced pressure, including from former prime minister Paul Keating, to buy long-term bonds to counter upward pressure on the Australian dollar.

In November it relented, announcing the first of two $100 billion quantitative easing or bond purchase programs. The commencement coincided with the announcement that COVID-19 vaccines had been developed that would allow the global economy to reopen.

A threat of prolonged deflation was replaced with that of inflation and bond yields began to climb.

A gradual rise in bond yields morphed into one of the most rapid sell-offs in history. While the 10-year rate almost doubled from 0.8 per cent to 1.6 per cent, it remained around historic low levels.

For Australia it meant the debt servicing constraints of the previous decades had been removed, giving the Coalition an apparent licence to spend.

On May 11, 2021, Frydenberg handed down his third budget. The quest for a surplus was no longer a political imperative as a $161 billion deficit was flagged. He was prepared to borrow and spend, and the Treasury said it could be afforded.

Even with higher borrowing costs, interest payments amounting to 0.7 per cent of GDP were well below the 2 per cent peak in the early 1990s when Kerin eyed the 10-year rate with anxiety.

Frydenberg’s budget forecast Australia’s government bond market would top $1 trillion by 2022. It is a figure that seemed unimaginable 70 years ago, when the Financial Review’s first edition reported the failure of a £40 million raising. And it was even more unlikely 35 years ago when the nation’s status as a developed economy was being questioned. AFR

The article is an extended version of a history of the bond market that first appeared in the Financial Review on 13 June 2012.