World Bank spread only 4 bps

If the cash rate in Australia is headed back to what the Reserve Bank of Australia, and others, like to define as a neutral range of say 4.5 per cent to 5.0 per cent over the course of next year, what impact will that have on financial markets?

Government bond yields will rise and this will flow through to all other forms of debt.

So borrowing will be more expensive and should slow or even halt any boom in the housing market, which is no doubt what the RBA intended.

It is also a good thing that future budget deficits are now expected to be smaller than predicted, just in May. Commonwealth government bond issuance may peak at no more than A$200 million, rather than A$300 million, according to some recent estimates. This will take some pressure off the domestic bond market and mitigate any possible crowding-out affects.

Rising interest rates should be partially offset by narrowing credit spreads. The reduction in credit spreads generally has been under way since the investment grade CDS indices peaked in March. It has also been evident in the credit spreads that the major banks have had to pay for their wholesale funding and even in the credit spreads paid by sovereign, supranational and agency (SSA) issuers in the domestic corporate bond market.

Last week, the World Bank issued A$800 million of five-year bonds at a spread of just four basis points over swap and 54.5 bps over Commonwealth government bonds.

The World Bank paid more for its second tranche, A$600 million of ten-year bonds at 15 bps over swap and 80.25 bps over CGS.

 SSA issuance resumed in the domestic market only in April and at that time a five-year issue from European Investment Bank commanded a spread of 75 bps over swap.

(The World Bank's sister organisation International Finance Corporation issued A$750 million of five-year bonds in June at 60 bps over.) SSA issuance will soon be taking place at sub-swap levels again, if conditions continue to improve.