Australia's AAA rating, going, going...?

Matt Mulcahy, Macquarie Fixed Income and Currency
Thursday 12 January 2017

A narrow escape with a real test in May

Despite much speculation and hype in financial markets and the press, Australia narrowly avoided a downgrade to its AAA rating in December.

The Government's Mid-Year Economic and Fiscal Outlook was weaker than expected with a $A10bn worsening in the deficits across the forward estimates due to lower forecasts for inflation and wages growth. However it did maintain its forecast for a return to surplus in 2020/21, which was enough to retain the AAA rating form all three major rating agencies for now.

Whilst S&P affirmed Australia’s AAA rating on a negative outlook the agency noted that there also needs to be real and measurable improvement “… in the government's willingness and ability to enact new budget savings or revenue measures to reduce fiscal deficits materially over the next few years.” They also said they "remain pessimistic about the government's ability to close existing budget deficits and return a balanced budget by the year ending June 30, 2021".

Any further delay in the forecast return to surplus beyond 2021 would, in our opinion, be sufficient to trigger a downgrade from S&P. So all eyes now turn to the 2017 May Budget where we will get the first actual projections for 2021.


Driven by commodity prices

Given the inability of the current government construct to pass expenditure savings measures through both houses, the ability to return to surplus by 2021 hinges on increased revenues. This will largely be driven by the future direction of Australia’s key commodity prices. If commodity prices remain higher for longer, then it is more likely a surplus will be delivered on time. The Treasury’s forecasts for iron ore and coking coal are respectively $US55/t by 3Q17 and $US120/t by 1Q18. These estimates look conservative considering historical prices for both commodities making a surplus realistic yet dependant on the resilience of commodity prices.

Source: Bloomberg

 

Source: Bloomberg


Investment implications

If the Australian government’s rating were cut in the future to AA+, the rating will merely match that of many other developed economies. The group of S&P AAA rated sovereigns has dwindled to twelve as many governments have been downgraded in recent years.

Current top sovereign credit ratings

AAAAA+AA
Australia Finland France
Canada Austria New Zealand
Denmark United States United Kingdom
Germany    
Netherlands    
Sweden    
Norway    
Singapore    
Switzerland    
Liechtenstein    
Hong Kong    
Luxembourg    


Source: based on S&P ratings

On the announcement of a downgrade, we would expect a knee jerk sell off in Australian bonds and would expect the Australian dollar (AUD) to depreciate anywhere from 1 - 2%. However we would not expect these reactions to be sustained. The reaction by the New Zealand dollar (NZD) following the cut to the New Zealand government’s credit rating from AA+ to AA on 29 September 2011 provides a more recent example. NZD dropped about 2 cents over two days in the immediate aftermath of the rating cut, but the drop in the NZD was not sustained. NZD recovered all its losses and more in the following week. 

The impact on the Australian bond market is a little more uncertain. In recent years Australia has been considered a high yielding AAA country which led to significant offshore interest to purchase its debt. In the middle of 2012 offshore investor ownership accounted for almost 80% of all Commonwealth government bonds on issue. More recently that offshore ownership has fallen to 57% as the increased issuance due to larger deficits has not been met with increased purchases. Whilst we would not anticipate a downgrade to force offshore investors to sell the current bonds they own, the willingness and ability to purchase new issuance may decline which would mean higher yields are required to finance the debt requirements. 

Source: Australian Bureau of Statistics and AOFM

The downgrade would also mean that the Australian major banks would likely be downgraded from AA- to A+. Given banks are heavily dependent on issuance in other currencies, a downgrade in their rating would make their bonds less attractive to offshore investors, and it would be expected that such a downgrade to the banks would lead to higher funding costs for them. Ultimately an increase in borrowing costs for banks would mean more expensive mortgages and tighter financial conditions in Australia. All else being equal this could possibly see the Reserve Bank of Australia being forced to lower rates further to offset these higher rates being passed on by the banks.

Therefore a rating downgrade for Australia could ultimately lead to lower cash rates and higher yields on the longer end of the curve. Using similar trades to the ones currently implemented in our fixed interest strategies, it is possible to take advantage of such moves by positioning for a steepening of the Australian yield curve.

All eyes now turn to commodity prices as we await the May Budget.

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