Why interest rates are dropping

Official rates remain frozen, but retail competition is hotting up.

Summary: The unchanged stance on official rates is not deterring fierce rates competition.

Key take-out: Investors need to weigh up the pros of locking in a low fixed rate with the prospect of further cuts.

 

The Reserve Bank board meets once again tomorrow for its regular monthly meeting and is widely expected to keep official interest rates on hold at 1.5 per cent for what will now be the 31st month.

It’s a record-breaking run of rates inactivity from the RBA, and most economists don’t expect a change to the cash rate anytime soon either. On that basis, we could all see out the rest of this decade with official interest rates at an all-time low.

What’s more, the majority of economists believe the next move – whenever that does eventually happen – is more likely to be down than up.

In fact, 60 per cent of the more than 50 economists listed by financial data comparison website finder.com.au are predicting a rate fall, which is a huge change from just a couple of months ago when almost 80 per cent were tipping the next move by the RBA would be a rate rise.

The dynamics for Australian interest rates haven’t changed markedly over recent times, with factors such as soft economic growth, benign inflation conditions and low unemployment continuing to shape the RBA board’s holding strategy.

But what has changed the economic dialogue is a speech by RBA Governor Philip Lowe delivered in January, when he stated that the central bank board was now more “evenly balanced” between next announcing a cash rate rise or a rate cut.

That’s shorthand for taking an each-way bet on how the Australian economy will perform over the medium term, with the prospect of weaker conditions increasing the potential for rates to fall.

Westpac chief economist Bill Evans has broken ranks with his other major bank counterparts, tipping the RBA will cut interest rates by 25 basis points twice this year, in August and November. That would take the cash rate down to 1 per cent.

This takes into account the RBA revising down its GDP growth forecast to 2.2 per cent, from 2.6 per cent this year.

“The decision by the Reserve Bank Board to accept the possibility that interest rates could fall further, despite the current record low levels, is profoundly important,” Evans said in a research note last week.

“We can now be confident that if our growth profile does evolve the Reserve Bank will be prepared to act.”

Evans estimates that the RBA will stay in a holding pattern to see if weaker conditions persist, which allowing for the release of more substantiating data, such as multiple inflation rate updates, would see the central bank produce an initial rate cut in August.

Competition heats up

Yet, the economics of rates is almost a side game to what’s actually happening in the retail space.

Although access to finance has become tougher for borrowers, those able to secure funding are locking in some of the lowest mortgage rate deals on record in Australia.

Borrowers, including property investors, are readily pinning down variable and fixed rate deals below 4 per cent, with principal and interest mortgages below 3.6 per cent becoming easy to find for owner-occupiers on 80 per cent loan-to-valuation ratios. Investors can also snap up loans below 4 per cent.

While some lenders including the “big four” have been edging their rates higher for existing borrowers, new borrowers are benefitting from stiffer market competition, which is driving down both variable and fixed rates on many products.

The lowest deals currently are variable rates of 3.44 per cent offered by Reduce Home Loans and Freedom Lend, positioning them ahead of all the major bank and other second-tier lenders.

The entry of new home loans player Athena, which has the backing of retail bank Macquarie, industry super fund Hostplus, and venture capital groups Square Peg and Air Tree, is also promising to keep other lenders on their toes.

After soft launching late last year, it has just hit the retail market with an introductory variable rate loan of 3.49 per cent.

“We’ve got a mission to help Aussies save a whole bunch of money by helping them pay off their loan faster. We’re proudly not a bank and never will be,” said co-founder and CEO, Nathan Walsh.

The battle for variable mortgage customers is proving to be fierce, and there’s also strong competition in the fixed rate space. Borrowers are able to lock in rates below 4 per cent for up to three years, and five-year rates just above 4 per cent.

What’s occurring in Australia is similar to what’s taking place in other markets.

In the US right now, even though the Federal Funds Rate is sitting above ours at 2.25 per cent, mortgage borrowers are still able to lock in 15-year fixed rate deals at 3.99 per cent.

The UK cash rate is sitting much lower than ours at 0.75 per cent, although variable rates there have been creeping higher, averaging 4.24 per cent. But borrowers are still able to secure introductory two-year fixed rate loans as low as 1.44 per cent.

Does locking in make sense?

The big question for Australian borrowers is whether it’s better to stay in a variable rate loan at this juncture, or whether locking in a medium-term fixed loan is a safe bet?

That decision needs to be assessed against one’s personal circumstances, and also against the economic views that are increasingly leaning towards an official rate cut by the RBA.

It’s currently possible to lock in a five-year rate of 3.74 per cent, a two-year rate of 3.58 per cent, or even a one-year deal at 3.49 per cent.

If the cash rate is moved down here over 2019 by 0.5 per cent, as Westpac’s Bill Evans forecasts, there’s still no guarantee lenders will follow suit by cutting their own rates. On the other hand, there’s always a risk in locking in a fixed rate if rates do fall in the future. Loan break costs can be high.

Perhaps the safest pathway would be to keep part variable and part fixed, but again it comes down to your overall ownership strategy.

Either way, most borrowers have never had rates as low as they are now.

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