What's going on with fixed rate loans?

The Reserve Bank of Australia has told us that rates are effectively on hold for a while. How long? We don’t know and unfortunately, the normal spread of economic indicators are less useful than they used to be in trying to gauge when a central bank may next move rates. The days of a central bank solely targeting inflation are long gone and most seem to have a spread of targets now. The Bank of England for instance, publically announced that it has no economic targets, and while the US Federal Reserve has an unemployment and inflation mandate, these have proven to be adjustable when its looks like they might be reached. The RBA itself appears to be trying to balance conflicting targets - the exchange rate, inflation and financial stability.  

With that in mind, market pricing suggests the next rate move for Australia will be in 2015, perhaps May or June, and that this will be a rate hike. Market pricing for a hike may firm over the year following the Reserve Bank of New Zealand’s decision to hike rates just this week - 25bp to 2.75% - the first advanced economy to do so.  Either way, and to varying degrees, it appears that central banks are at least starting to rein in the excessive amounts of monetary stimulus flooding global markets.

Against that backdrop it appears odd that fixed lending rates in Australia continue to fall.  Indeed NAB recently (January) cut its 4-year fixed lending rate to a 20-year low. Modest 0.05% reductions on fixed 3 and 5-year rates soon followed.  Other banks too have cut some fixed-rate loans - ANZ and Westpac recently cutting 2 and 3-year fixed-rate loans. Similarly, CBA announced that rate cuts independent of the RBA were plausible.  

The moves are odd though given what we know, and given central bank rhetoric both here and abroad.  So what gives?

It’s not that its necessarily unusual to see the yield curve (of lending rates of various maturities) flatten (longer rates falling relative to short-term rates during a period of stable rates). We’ve seen it before although theories as to why it happens vary. Often it’s a simple case of investors chasing higher yields, which lowers borrowing costs for banks. A stable interest rate environment reduces the risk of capital loss. So income hunters come in.

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Yet that’s not what we find. Indeed the opposite is occurring and some longer-term benchmark rates have been rising. Indeed the Australian government benchmarks show that over the last year, 3 and 10-year lending rates have increased (chart 1 above). The 3-year bond rate is up 50bp and the 10-year  110bps since the lows recorded in 2013.

Why does this matter? Because if the rate at which government can borrow is lifting, then this will put upward pressure on the rate at which banks themselves can borrow longer term.  It’ll put upward pressure on fixed mortgage rates. I can appreciate that a rate hike here is probably some-time away, so banks may not be feeling the rate hike pressure. Even so, this isn’t the usual backdrop where fixed rates fall.  Similarly, and at the very least, most would agree the days of cutting are over. The economy is stronger than expected, inflation is higher than expected and the housing market is strong. Credit growth is accelerating. While we are nowhere near a danger zone yet in terms of the property market or inflation etc - rates are at record lows and the run of data at the very least, raises question as to how appropriate record low rates still are.

Admittedly there doesn’t appear to be too much pressure on wholesale funding costs for banks at this point in time, notwithstanding the recent lift in government lending rates.  Indeed, the RBA noted in its recent Statement on Monetary Policy recently that “Over the past three months, the cost of banks' new issuance of unsecured long-term wholesale debt has been little changed, and remains at around its lowest level since mid-2009. The outstanding cost of wholesale debt has started to decline over the past few months as some of the debt issued in 2008 and 2009 at high spreads has matured. This has had a limited effect on banks' overall funding costs to date as long-term wholesale debt currently represents only 15 per cent of banks' total funding.”

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So again this isn’t really a case for cutting fixed rates. The most likely candidate for the cheapening in fixed rate mortgages is the recent fall in  domestic deposits rate offered by the banks. This source of funding accounts for up to 50% of a bank’s needs and terms deposit rates are coming down, - from an average of 3.25% mid 2013, to 2.95% now. No doubt this reflects improved conditions in short-end wholesale markets, where the cost of raising funds for banks is cheaper: the 6 month BBSW rate is below 2.7% and the 1-2-year swap rate is at 2.66 and 2.84% respectively.

I would have thought there is a limit to this though - rising property and equity markets would suggest a limit to how much lower banks can take this - before deposit holders find more productive uses for their funds.  Like a bank’s dividend yield which is multiples of any term deposit!

The fact remains that without a meaningful decline in wholesale funding costs, it’s not clear that recent falls in fixed rates can be sustained, or rather can be repeated to any great degree. This at a time government bond rates are rising - and the whole term structure is on the up (if just slowly).

Don’t forget that the big four banks have a 92% market share at the moment - on the proportion of new loans being written.  This is up from 78% prior to the GFC. This is important because it doesn’t exactly point to huge competitive pressure in the market.  In turn this doesn’t really add to the case that fixed rates can continue coming down.  There is little pressure for banks to give away much of the gain in net interest margin gained since the GFC. This is not something they would like and it’s not something the RBA - as overseer of financial stability - would like either, noting the absurd amount of pessimism on Australia’s banks.

On the flipside, demand side pressure for fixed rates is lifting, quite sharply in some cases with CUA noting that 55% of new customers are opting to fix. More broadly, data from the Australian Bureau of Statistics shows a rising proportion of borrowers fixing in.

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Noting all of the above, don’t think we can be too far from the trough in mortgage rates, even if banks have only just cut them.  We may not be exactly at the low, but the lift in capital market rates and noises we are hearing from central banks - not to mention the data flow - strongly suggest we can’t be too far from it. Especially as demand for these products is rising.  For investors, this would suggest now would be a great time to fix in any borrowings you may have.