For the first 11 months of 2018, Morrison is now $22 billion ahead of these estimates on the net operating balance measure and $19 billion better off on an underlying cash basis. While it's certainly conceivable that the month of June could lurch back into deficit and erode these gains, the fact remains that analysts and rating agencies excoriated Morrison for being far too optimistic in his 2017 budget. And yet he has massively outperformed these numbers by about $20 billion in 2018 alone.

Subject to how June goes, Morrison could deliver a full-year budget surplus on two of the three key measures (he will likely have a deficit on an underlying cash basis), and is all but certain to move the budget into surplus this financial year on all benchmarks.

Key drivers

The only other analyst I could find that has picked up on this is CommSec's Craig James, who comments that this is the "smallest rolling annual deficit for nine years". "For the 11 months to May the operating balance is almost $2 billion in surplus – over $7 billion better than [the government] expected [only two months ago in its May budget]," James says.

The driver of Morrison's upside surprise, which this column has flagged as probable since 2017, is attributable to better than expected commodity prices, labour market conditions, and overall economic growth. "Record employment growth and company profits have boosted government revenues while at the same time the government has trimmed its spending," James explains.

This will likely compel S & P's sovereign analyst KimEng Tan to consider taking the AAA rating off its "negative outlook" and restoring it to a "stable" footing, which few thought possible 12 months ago.

S & P's Sharad Jain has already flagged that the agency is contemplating upgrading Australia's economic risk score from 3 to 2 (lower is better), which would lift the credit ratings on the major banks' hybrids from BB+ to BBB-. It would also improve the ratings on their subordinated bonds to BBB+, which all else being equal should ameliorate their funding costs.

While Aussie house prices have corrected 2.5 per cent from their October 2017 peak (Sydney prices are down 5 per cent), confirming our April 2017 call that the boom was over, there are no signs of the hysterical "credit crunch" imagined by the likes of UBS's Jon Mott.


According to the Reserve Bank of Australia, housing credit expanded, not contracted, by 0.4 per cent in May and has increased by a handsome 5.8 per cent over the last 12 months. There has been a welcome deceleration in overall housing credit growth in recent years as regulators pushed banks to substantially boost the conservatism of their lending standards since 2014.

This is most evident in lending to property investors, which was flat in May and has risen by only 2 per cent over the last year, which CBA's Kristina Clifton says is "the slowest pace of investor credit growth on record". While housing credit growth will continue to soften, it is not going to contract as sharply as UBS's Mott warns, with the RBA backing our argument that any additional tightening in lending standards is likely to be modest.

Crucially, this normalisation in housing credit growth towards the rate of change in national incomes is precisely what credit rating agencies have wanted to see. Aussie housing has been heinously expensive for some time, and we desperately needed an orderly mean-reversion in valuation fundamentals, which is exactly what is happening.

Bank funding costs

A short-term headwind for housing will be further out-of-cycle interest rate hikes as the banks recover elevated funding costs wrought by a hike in the short-term price of money. On this note, there has been much debate as to why these short-term funding costs spiked in Australia at the end of the June quarter, but not in the US or anywhere else.

This has created a pattern whereby both unsecured and secured borrowing costs for Aussie banks have leapt at the end of the December, March, and June quarters. Earlier in the year it was posited that this may have been fuelled by a similar rise in US short-term rates in March, but this did not manifest in December or June in what appears to be a peculiarly Antipodean perturbation.

After speaking to banks, one causal explanation seems persuasive: a huge jump in the demand for Australian dollars from hedge funds seeking to use Australian repurchase (or "repo") agreements to provide cost-effective financing, or leverage, to fund government bond futures basket arbitrage trades and foreign exchange arbitrage. In 2015 these "non-residents" only borrowed about $20 billion via Australian repos. This had leapt $60 billion to almost $80 billion by March 2018.

In a world where banks are subject to much tougher capital adequacy and liquidity standards, which are reported on a quarterly basis, it makes sense that they may seek to reduce the dollar value of lending they do via repo as they approach quarter-end. This would explain why repo rates have surged in the final week of the last three quarters. And as these secured lending rates climb, they inevitably affect unsecured borrowing costs as represented by the bank bill swap rate, which has tracked the quarterly spikes in repo rates.

Other contributing factors include: a drop in deposit growth that has generated more demand for short-term borrowing; a striking increase in competition from foreign (mainly Asian) banks that are using more short-term funding; the unusual situation where Australia does not centrally clear its repo trades like best-practice overseas, which the Bank for International Settlements says reduces liquidity and increases execution costs; and the fact that budget surpluses are resulting in the government depositing much more money with the RBA, which is buying overseas assets it hedges back into Aussie dollars that creates yet more demand for local currency and puts upward pressure on short-term rates.

The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.