Speech
How Developments in International Financial Markets Shape Financial Conditions in Australia
Penelope Smith
*
Head of International Department
Australian Securitisation Conference
26 November 2025
–
Sydney
Audio
26.2MB
Q&A Transcript
I would like to begin by acknowledging the Gadigal people of the Eora Nation, the traditional custodians
of the land we are meeting on today. I pay my respects to their Elders past and present. I also extend
that respect to all Aboriginal and Torres Strait Islander peoples joining us today.
It’s a privilege to be here at the Australian Securitisation Conference.
A key role of International Department at the RBA is to provide advice on developments in international
financial markets to the Monetary Policy Board and to work with colleagues across the RBA to interpret
what these developments mean for financial conditions in Australia. 1
The aim of my talk today is to provide a flavour of how we do this. I’ll recap some key developments
in international financial markets over the year and then explain our framework for thinking about how
these developments can affect financial conditions in Australia, focusing on the distinctive features of
the Australian financial system that shape the transmission of global financial market shocks.
In the interest of time, I won’t cover other important international linkages, including economic
transmission channels, where global financial conditions affect global activity that transmits to
Australia, or the transmission of shocks during periods of financial stress or market dysfunction. These
have been covered in other recent RBA publications and speeches. 2
The year in review
This year has certainly been eventful. The global financial system has been affected by a convergence of
interrelated forces. Policy uncertainty has at times been extreme as the US administration has disrupted
established policy norms (Graph 1). Concerns about global fragmentation have been heightened. But
despite some bouts of volatility in markets, including in recent days, risk premia have been low, fuelled
by optimism about AI, more supportive policy settings and as the more adverse scenarios for global growth
have not materialised.
Graph 1
Central banks have eased policy rates cautiously …
Central bank policy rates are one of the most important determinants of global financial conditions.
Almost all central banks in the major advanced economies reduced their policy rates in 2024 and 2025 as
inflation eased from post-pandemic highs and labour markets cooled. Japan was the exception, gradually
tightening monetary policy in response to inflationary pressures after decades of very low inflation.
Most central banks have taken a cautious approach as they have navigated the extreme policy uncertainty
and while inflation remains a little above their targets due to sticky services inflation. Market
expectations are for further gradual policy easing in some advanced economies over 2026, most notably in
the United States (Graph 2).
Graph 2
Central banks have also continued to run down their balance sheets, in a way designed not to impact
financial conditions meaningfully. Some have concluded, or signalled they are close to concluding, this
process. The US Fed recently announced it will end its balance sheet run-off in December. This reflected
a judgement that reserves were nearing ‘ample’ levels, given signs of pressure in a range of US
money market rates.
… amid concerns of increased global fragmentation.
The potential for global fragmentation has been a major theme of 2025. Over the second half of the 20th
century and most of the 21st century to date, increasing global integration has supported growth in
advanced and emerging economies. This was underpinned by policies that have made it easier for goods and
services, capital and ideas to flow across borders.
However, support for such policies has been waning for a number of years in the United States and
elsewhere, in large part because the gains were not always distributed evenly. Inequality, including
between regions, and the post-pandemic surge in inflation, which reduced real incomes, has provided
impetus to growing political polarisation and nationalism. At the same time, geopolitical tensions have
been rising.
Protectionist policies have the potential to cause a retrenchment of global trade and capital flows that
would undermine welfare globally. The risk of regulatory fragmentation across the international financial
system has also been increasing, as jurisdictions pursue diverging regulatory priorities, including in
banking and digital assets.
The good news is that a retrenchment of global trade and capital flows has been more of a fear than a
reality in 2025, at least so far (Graph 3). Capital flows, including into the United States, remain
high. Global supply chains have been surprisingly resilient and adaptable, perhaps drawing on the lesson
of the pandemic. Effective US tariff rates, while still much higher than at the beginning of the year,
are lower than originally feared in April. The AI infrastructure boom has also supported trade, and by
more than many expected.
Graph 3
Questions have been raised about the US dollar’s ‘safe haven’ status …
The role of the US dollar in international markets has received some attention this year. Concerns
about the US administration’s policies, including the potential for lasting damage to key
institutions, have led some commentators to question whether the US dollar can maintain its
longstanding ‘safe haven’ or reserve currency status. Typically, the US dollar strengthens
when global aversion rises, but after the April tariff announcements, the US dollar depreciated,
while US Treasury yields spiked and equities fell (Graph 4).
Graph 4
Overall, the concerns about the status of the US dollar seem to have been overstated, at least for
now. There are currently no clear alternatives to the US dollar as the world’s dominant
currency. While the US dollar has depreciated by 6 per cent on a trade-weighted basis over
2025, this was from a near historical high at the end of 2024. Much of the depreciation can be explained
by standard macro determinants, including narrowing interest rate differentials between the United States
and the rest of the world.
Foreign reserves of central banks and governments have not shown an accelerated move away from the
US dollar in 2025. The US dollar’s share in official foreign exchange reserve portfolios
continued to decline gradually this year, consistent with the trends of recent years (Graph 5). But
the decline in 2025 is mostly explained by valuation effects from exchange rate movements. It has not
reflected a generalised reallocation away from US dollar assets in reserve managers’
benchmarks.
Graph 5
There is also little evidence of a significant reallocation away from US dollar assets by other asset
managers. Nevertheless, there is evidence that some market participants are looking to manage increased
risks around the US dollar. Market reports and our own liaison indicate that some non-US asset
managers have increased their hedging of US dollar assets even though it is relatively costly to do
this when US interest rates are higher than elsewhere. 3
… and concerns about fiscal dynamics in some countries have put upward pressure on sovereign bond yields.
Fiscal dynamics have been in focus in a number of economies overseas. The cumulative impact of responses
to the global financial crisis and the pandemic have left gross government debt ratios higher
(Graph 6). In some countries, political polarisation is making it challenging to reach agreement on
policies to put fiscal settings on a more sustainable path. Ageing populations, adaptation to the
physical effects of climate change, and increased defence spending in response to geopolitical tensions
will continue to add to fiscal pressures over coming years.
Graph 6
Partly reflecting fiscal challenges, ultra-long end bond yields and term premia have risen over 2025 in
some countries (Graph 7). The investor base for ultra-long bonds has also been changing. 4
Hedge funds are
reportedly holding a larger share. While hedge funds contribute to greater market depth and efficiency in
normal times, their use of leverage can amplify shocks. We saw this during the April market turmoil with
the unwind of the so-called swap-spread trade that arose in anticipation of an easing of US bank
regulation. 5
Graph 7
Depsite significant uncertainty, risk premia in global markets have been low …
Despite elevated policy uncertainty, market participants have been willing to accept very little
compensation for risk. Equity prices have increased strongly in most advanced economies over 2025, and
valuations have been high in the United States and Australia, despite some recent declines
(Graph 8). Meanwhile, corporate bond spreads have been well below their long-term averages. Overall,
market pricing suggests that investors haven’t placed much weight on the possibility of materially
adverse outcomes for most of the year, except for a brief period after the April tariff announcements.
However, volatility has increased somewhat in recent weeks.
Graph 8
Market optimism around AI, which has been tested a little of late, is one reason risk premia have been
compressed. Other factors have been expansionary fiscal settings in some countries and more supportive
monetary policy. Confidence also grew as worst-case scenarios around tariffs failed to materialise, along
with generally better-than-expected corporate earnings, especially in the tech sector. In Australia, the
recent decline in equity prices, which is larger than the decline in US equity prices, has coincided with
an upwards revision in expectations for the cash rate and other domestic news.
The question of over-valuation in markets is a key one. With some asset valuations appearing very
stretched, a reassessment of the risks or optimism around AI or corporate earnings, could see equity and
corporate bond markets shift quickly from currently contributing to easier global financial to something
less easy, and possibly even tight or disruptive.
… while gold prices have risen sharply.
Gold prices have been another big story in 2025. US dollar prices have increased by a staggering
54 per cent over the year to date to record highs – the fastest annual increase since
1979 (Graph 9). 6
Graph 9
What’s driving the increase? One factor is geopolitical tensions and the threat of sanctions. Central
banks in some emerging markets have been increasing the share of gold in their reserves portfolio since
Russia’s reserves were frozen in 2022 in response to the full-scale invasion of Ukraine. This trend
may have further to run, with emerging market central banks still having smaller allocations to gold than
many of their advanced economy peers.
Gold is also often considered a hedge during times of global uncertainty. This year, concerns about global
fragmentation, US policy risks, including tariffs and perceived threats to Fed independence, and fiscal
sustainability in several economies may have added to that appeal. But this explanation is hard to square
with still very low risk premia in financial markets and stable long-term inflation expectations.
There are also some clear signs of speculative buying, including significant retail buying via exchange
traded funds and queues forming to buy physical gold.
How do global developments affect financial conditions in Australia?
So what does this mean for financial conditions in Australia? First, let me explain exactly what I mean by
financial conditions. Financial conditions represent the cost and availability of finance for households
and businesses to support economic activity. Conditions are ‘restrictive’ when the cost of
finance is high enough to place downwards pressure on aggregate demand and ‘easy’ when the cost
of finance is low.
Monetary policy works primarily through its influence on financial conditions. Yet, while important, the
RBA’s cash rate is not the only influence on the cost of finance in Australia. Expectations for
inflation and the path of central bank policy rates have an important bearing, along with the
compensation that investors require for bearing risk.
As Assistant Governor Christopher Kent recently outlined, an assessment of whether conditions are
restrictive or tight needs to be benchmarked to something. 7
This is where the neutral interest rate comes
in. The neutral rate is the conceptual equilibrium short-term interest rate that keeps growth at
potential and inflation at target when no other shocks are hitting the economy. If the cash rate was held
steady, but the neutral rate declined, then financial conditions would be tighter than otherwise, all
else equal.
Developments in international markets have a significant influence on these determinants of financial
conditions in Australia. Key channels of transmission include global influences on the neutral interest
rate, spillovers from faster moving risk and term premia that are correlated across countries, and the
exchange rate. I’ll now discuss each of these in turn.
Australia’s neutral interest rate is influenced by global and domestic factors.
In small open economies like Australia, the neutral rate is heavily influenced by international
developments that affect the balance of saving and investment globally. 8
In recent decades, estimates of real neutral interest rates have fallen across advanced economies,
including Australia (Graph 10). This fall reflected a secular rise in global saving that was
unmatched by higher global investment.
Graph 10
A significant body of research has sought to explain why neutral rates fell. Explanations include the
integration of high-saving fast-growing emerging markets into the international financial system, slower
trend productivity growth, ageing populations, and rising inequality. Demand for safe assets also surged
after the global financial crisis because of tighter financial regulation and while the long process of
deleveraging dampened investment.
There is less consensus about the trajectory of neutral rates after the pandemic. Different approaches to
estimating neutral rates provide different answers, underscoring the significant challenges in
estimation. Some estimates have increased. This is the case for the estimates I’ve shown here, which
are produced by James Morley from the University of Sydney and Benjamin Wong from Monash University. 9
Estimates based
on financial market pricing have increased by a little more. However, other commonly used approaches,
based on macroeconomic models, show little to no increase. 10
The future trajectory of neutral rates is also uncertain. Factors that could push neutral rates higher
include growing fiscal deficits, a decline in the demand for safe assets if there is a loosening of
post-crisis regulation, or a sustained increase in productivity growth arising from AI. At the same time,
many of the factors that depressed neutral rates before the pandemic have not gone away. Despite AI
optimism, productivity growth outside the United States has remained weak, and there will be continued
population ageing. 11
The effects of AI on inequality are uncertain.
How greater global fragmentation could affect neutral rates is also ambiguous. While it could lower
productivity growth, pulling neutral down, it could also restrict capital mobility from high-saving
emerging markets, putting upward pressure on neutral rates in advanced economies like Australia. 12
Bringing this all together leads to the somewhat unsatisfactory conclusion: there is a lot of uncertainty
about where neutral rates are and where they are going. What we can perhaps conclude, though, is that
they have not fallen since the pandemic and may have even risen.
While the uncertainty may seem discouraging, it is still important to engage with, and in, research and
analysis that help us to understand how neutral rates might be changing. Being slow to recognise
international developments that might change Australia’s neutral rate is a potential source of error
in monetary policy decision-making.
How much influence do international developments have on Australia’s neutral rate? That’s also
very uncertain. Morley and Wong estimate that foreign shocks have explained about half of the variation
in Australia’s neutral rate since the mid-2000s. They also find that estimates of the US neutral
rate on its own is almost entirely sufficient to explain the global influences on neutral rates in
Australia and in several other advanced economies.
The finding that the US neutral rate can explain most of the influence of global factors on
Australia’s neutral rate is consistent with the United States’ central role in the
international financial system. The US dollar accounts for more than half of foreign exchange
reserves held by central banks, it is the dominant invoicing currency for international trade, and a
reference point for pricing a wide range of financial instruments. Australia’s external assets and
liabilities that are denominated in foreign currencies are overwhelmingly denominated in US dollars.
Risk and term premia in Australia move closely with those in other advanced economies.
Next, let me talk to the role of international spillovers into Australian financial conditions from faster
moving risk and term premia. These premia are highly correlated across countries. In 2025, measures of
equity risk premia, corporate spreads, and term premia in Australia moved closely with those other
advanced economies (Graph 11).
Graph 11
The structure of Australia’s financial system means that risk and term premia have less influence on overall financial conditions …
However, the structure of our financial system means that developments in capital markets are less
important for overall financial conditions in Australia than in some other economies like the United
States.
Our financial system is dominated by banks, which account for around 95 per cent of household
credit and two thirds of business debt, which means businesses’ borrowing costs are much more
heavily influenced by bank lending rates than by the cost of capital market funding (Graph 12). 13
Graph 12
Another salient feature of Australia’s financial system is that stock market wealth is mostly held
indirectly through superannuation. This is largely inaccessible until retirement, and previous research
has found little connection between changes in stock market wealth and household consumption in
Australia. 14
Additionally, as I will expand upon below, the Australian dollar exchange rate tends to appreciate with
increases in riskier asset prices, including US share prices. The appreciation of the exchange rate
tightens domestic financial conditions, offsetting at least part of the effect of the decline in risk
premia on overall financial conditions.
Sovereign bond yields also tend to be correlated across economies. However, international spillovers tend
to be largest at the longer end of the yield curve. 15
In Australia, it’s the short end of the yield
curve that matters most for financial conditions, with most household and business lending undertaken at
variable interest rates and most fixed-rate lending at terms of two years or less. 16
Short-term
interest rates in Australia are mostly determined by domestic factors with the cash rate target being the
most important influence. 17
… and the exchange rate acts as a buffer against global shocks.
The exchange rate is one of the most important determinants of Australian financial conditions next to the
cash rate. It is a key channel of transmission for monetary policy, and acts as a buffer against global
shocks. 18
The two key long-run determinants of the level of the Australian dollar are terms of trade, which is
heavily influenced by commodity prices, and the interest rate differential between Australia and other
major advanced economies. Meanwhile, global risk sentiment, which can be proxied by the volatility index
measure of option-implied volatility or global equity prices, is important for explaining short-run
changes in the Australian dollar, which tends to depreciate when global risk appetite declines.
Now, while the relationships between the Australian dollar and its key determinants hold on average, they
don’t necessarily hold at every point in time. 19
At times, the exchange rate can influence financial
conditions independently of interest rate differentials and the terms of trade. One way we monitor this
is to compare the level of the real exchange rate to estimates of its long-run equilibrium value. 20
Currently,
the real trade-weighted exchange rate remains within estimates of its long-run equilibrium, as it has for
most of the year (Graph 13).
Graph 13
This year, some have questioned if the relationship between the Australian dollar and global risk
sentiment has changed in light of the discussion about the safe-haven qualities of the US dollar. If
this were to occur, it could undermine the Australian dollar’s effectiveness as a buffer in
‘risk-off’ events, and against variation in risk premia more generally.
The first observation I would make is that the correlation between the Australian dollar and US equity
prices remained close to its historical average through most of the year, and
increased
during the April volatility, with the Australian dollar initially depreciating sharply alongside falling
US equity prices. 21
I would also observe that Australia is a small open commodity exporting economy that is exposed to both
the level and composition of global growth. Nothing that has occurred in the United States changes that.
Australia could indeed become relatively more attractive to global investors over time, given our strong
institutions and comparably low levels of public debt. This would represent a structural decline in
Australia’s country risk premium and so a lower neutral rate. 22
However, even if that occurred,
the Australian dollar would still be likely to depreciate during global risk-off events, as it did during
the April market turmoil. 23
Of course, if this did not occur for some reason, and
the Australian dollar appreciated, the tightening effect of a sharp rise in global risk aversion on
domestic financial conditions would be amplified via the exchange rate.
Conclusion
To conclude, 2025 has been an eventful year for international financial markets. It’s also been a
year where policy uncertainty and market confidence have coexisted in extraordinary ways. So far, some of
the more significant downside scenarios that had been contemplated earlier in the year, including a
retrenchment of global trade or a significant market correction, have not materialised. Noting the recent
market volatility, this is something we continue to monitor closely.
International financial market developments affect Australian financial conditions through a number of
channels, including through global influences on our neutral rate, spillovers from internationally
correlated risk and term premia, and the exchange rate.
In 2025, compressed equity risk premia and credit spreads meant that financial conditions in Australia
were easier than otherwise. However, the structural features of Australia’s financial system, such
as the dominant role of banks, short-term debt contracts, and compulsory superannuation, mean that equity
prices and corporate credit spreads have less weight in overall financial conditions. The exchange rate
also acts as a buffer against global shocks.
That said, the current global backdrop demands constant attention. As April’s events reminded us, we
need to be prepared for potential episodes of volatility and potential market dislocation.
Endnotes
*
I would like to thank
Connor Thrall and George Tyler in the preparation of these remarks, which also benefited from the
comments of many colleagues at the RBA. 1
International
Department is also responsible for: the RBA’s foreign exchange operations; investment of
international reserve holdings of gold and foreign exchange; maintaining relations with major
international financial and policymaking institutions; the provisions of technical assistance to
other central banks in the region; and the coordination of climate-related analysis across the
RBA. 2
For a recent
discussion of the transmission of financial stability shocks, see RBA (2025), ‘
4.1
Focus Topic: How Overseas Shocks Can Affect Financial Stability in Australia
’,
Financial Stability Review
, October. For economic channels of transmission, see
Hunter S (2025), ‘
Joining the Dots: Exploring
Australia’s Economic Links with the World Economy’
, Speech at the Economic
Society of Australia (Queensland) Business Lunch, Brisbane, 3 June. 3
In part due to the
ongoing high correlation between the Australian dollar and US equities, and the lower volatility
of the Australian dollar compared with US equities, Australian superannuation funds have not
significantly changed their hedge ratios so far this year. See Hauser A (2025), ‘
A Hedge Between Keeps Friendship Green: Could
Global Fragmentation Change the Way Australian Investors Think About Currency
Risk?
’, Remarks for a function hosted by CLS Bank International and NAB, Sydney,
16 September. 4
As pension funds in
some countries move from defined-benefit to defined-contribution pension schemes, their demand
for long-duration bonds is falling. In 2023, the Netherlands, which is home to the world’s
fifth largest pension sector, legislated a full transition to defined-contribution schemes by
January 2028. Defined-benefit funds and life insurers typically hold a larger share of
long-duration bonds to match their liabilities. 5
Leveraged investors
were reportedly positioned for a drop in longer term Treasury yields relative to similar maturity
swaps, partly on expectations that an easing of bank regulation would boost bank demand for
Treasuries. See Perli R (2025), ‘Recent Developments in Treasury Market Liquidity and
Funding Conditions’, Remarks at the 8th Short-Term Funding Markets Conference, Washington
DC, 9 May. 6
In 1979, gold prices
surged against a backdrop of high inflation and high unemployment, geopolitical instability from
the Iranian Revolution, and the Soviet invasion of Afghanistan. 7
Kent C (2025),
‘
Australian Financial Conditions – How
Do We Judge How Tight or Easy They Are?
’, Address to the CFA Society Australia,
Sydney, 16 October. 8
In the absence of
frictions in markets, risk-adjusted return should equalise across economies. This means
Australia’s real neutral interest rate should be the same as the global neutral rate, which
balances saving and investment in the global economy plus or minus an Australian-specific
‘risk premium’. In reality, though, there are frictions, such as home bias, that create
a significant role for domestic factors other than country specific risk premiums in determining
neutral. 9
I’ve used these
estimates because they’re estimated on a consistent basis across countries. Moley and
Wong’s estimates for Australia fall within the range of estimates from the RBA’s suite
of models. See Morley J and Wong B (2025), ‘How Important is Global r-star For Open
Economies?’, CAMA Working Paper No
24/2025
. 10
Williams J (2025),
‘All the Stars We Cannot See’, Remarks at the Banco de México Centennial Conference,
Mexico City, 25 August. 11
That said, as baby
boomers reach retirement age, that could also see a drawdown of saving in advanced economies. 12
Less capital
mobility would also lead to greater heterogeneity in economies’ neutral rates. 13
Australian
corporations, including by our banks, and the government borrow in international capital markets.
However, for Australia as a whole, foreign liabilities are almost entirely denominated in
Australian dollars, and those that are not are hedged for currency risk and duration matched.
This hedging means Australians corporations borrowing offshore, including our banks, are actually
paying Australian interest rates. See Kent C (2018),‘
US Monetary Policy and Australian Financial
Conditions
’, The Bloomberg Address, Sydney, 10 December. 14
May D, G Nodari and
D Rees (2019), ‘
Wealth and Consumption’
, RBA
Bulletin
, March. 15
Kearns J, A
Schrimpf and FD Xia (2023), ‘Explaining Monetary Spillovers: The Matrix Reloaded’,
Journal of Money, Credit and Banking,
55, pp 1535-1568. 16
In Australia,
around 95 per cent of household debt is currently variable rate, and most fixed-rate
mortgages are for short terms of two years or less. Similarly, Australian businesses borrow
primarily from banks and around 90 per cent of these loans are at variable rates. 17
Kearns, Schrimpf
and Xia (2023) also note foreign currency denominated debt and bilateral portfolio equity flows
from the United States or euro area as significant factors that determine the size of spillovers
into long-term rates. 18
See, for example,
Mulqueeney J, A Ballantyne and J Hambur (2025), ‘
Monetary
Policy Transmission through the Lens of the RBA’s Models
’, RBA
Bulletin
, April. In theory, there are two main channels of transmission from the
exchange rate to the economy: the trade channel and the financial channel. If the financial
channel of the exchange rate is strong in an economy, it can undermine the effectiveness of the
exchange rate as a buffer against global shocks. However, the financial channel of the exchange
rate is not an important channel in Australia. This is because most of Australia’s external
debt is denominated in Australian dollars and the debt that is not is hedged. See Smith P (2023),
‘
The Extraordinary Decline in
Australia’s Net Foreign Liabilities’
, Speech to the CFA Societies 2023
Australian Investment Conference, Sydney, 18 October. 19
For example, in the
late 1990s and early 2000s, in the wake of the Asian financial crisis and during the US tech
boom, our terms of trade were rising, yet the dollar fell sharply as capital flowed towards
‘new economy’ tech stocks and away from the ‘old economy’ assets that
dominated Australia’s exports. 20
Chapman B, J
Jääskelä and E Smith (2018), ‘
A
Forward-looking Model of the Australian Dollar
’, RBA
Bulletin
,
December. 21
See Hauser, n 3. 22
In the canonical
small open economy model, the domestic neutral rate is the global neutral rate plus a country
specific risk premium. 23
The longer-term
correlation between the Australian dollar and US equity prices remained close to its historical
average through the recent market turmoil, and the shorter-run correlation increased with the
Australian dollar initially depreciating sharply alongside falling equity prices. See Hauser, n 3.