Should homeowners and investors fix their mortgage rate, given that the RBA is now set to raise the cash rate substantially over coming months? The answer to that urgent question depends on another question – is inflation transitory, or will it persist?
If the economic factors that are driving the demand for goods and services up and driving supply down — such as high government spending, low interest rates, high commodity prices and supply chain snarls — prove to be ephemeral, then inflation will soon peak and fall away. Borrowers who lock in the current, relatively high, fixed rate will then regret their choice.
Alternatively, if the current high CPI figures flow into higher wages, causing high inflation to persist, then the RBA will have to raise the cash rate to much higher levels to get on top of inflation. In that case homeowners and investors who fix now will be glad they did.
Before discussing inflation, let’s first work out how much the cash rate would have to rise to give fixed rate borrowers a better outcome than variable rate borrowers over a three-year period.
If over the next year the RBA steadily raises the cash rate from its current level of 0.35% to 2.85% then, by my calculations, interest payments on variable rate mortgages and fixed rate mortgages will be about the same over three years. If the cash rate goes higher than 2.85% over the three years, then investors will have been better off if they fixed.
An example will demonstrate. Rates on mortgages fixed for three years are currently about 210 basis points (2.10%) above variable rates. Three-year, fixed rate mortgages with a loan-to-valuation ratio (LVR) of 80% for an owner-occupier paying P&I (principal and interest) are currently set at 4.35% with CBA. The same variable rate, with an offset account, is 2.25% with Athena. These figures are from ratecity.com.au on 31 May 2022.
The 2.00% extra interest on a fixed rate mortgage is 6.00% total extra interest over three years. Now imagine that the cash rate rises steadily by 2.50% over the next year, from its current level of 0.35%, and then settles at 0.35 + 2.50 = 2.85% over the remaining two years. The variable interest rate would be 1.25% higher in the first year (averaged over the whole year) than its current level, and 2.50% higher over two more years, to give the extra 6.25% over three years. I am assuming here that variable rates rise and fall in lockstep with the cash rate.
Will the cash rate reach 2.85%?
Variable mortgage rates will depend on the RBA’s decisions on its cash rate, which will in turn depend on how the inflation rate evolves. CPI in the first quarter of 2022 was 5.1% higher than a year ago, but the RBA is more concerned with core inflation (the trimmed mean) which was 3.7%. We should expect the RBA to raise the cash rate meeting-by-meeting until core inflation is back under 3%.
Will inflation fall back quickly or will it persist? The bond markets clearly think that inflation will be transitory. We know what levels of future inflation the bond market is predicting because the Australian Federal Treasury raises money by issuing both regular bonds and inflation indexed bonds.
The only difference between these two types of bonds is that inflation indexed bonds have built in protection against inflation (the principal of the inflation indexed bonds increases each quarter with CPI). So, the difference in the yield on regular bonds and inflation indexed bonds is the expected (or implied) inflation rate. Technically the difference in yields is how much bond investors are prepared to pay for inflation protection, but that is usually taken to be the same as expected inflation.
How much $A inflation is the bond market expecting in coming years? The bond market is expecting inflation to average 3.1% over the next 3 years and then fall back to 2.0%, which is the bottom of the RBA’s target range, and would make the RBA more inclined to cut rather than raise rates. The corresponding bond market inflation expectations in the US are similar – inflation falling back quickly from its current high levels to 2.3% within 18-24 months.
Bond market expects return of deflationary forces
The bond market clearly believes that the current powerful inflationary forces in the US and Australian economies are only the result of short-term factors — mostly to do with Covid19. Soon the powerful deflationary forces that have dominated the global economy for three decades before Covid19 appeared will reassert themselves. Those are the deflationary forces of: ageing populations; tech advances; globalization of workforces; and concentration of wealth.
We should remember the state of play with inflation immediately before Covid19 struck. In October 2019, fully three months before the first Covid19 death in Wuhan in January 2020, the RBA cut the cash rate to 0.75%, which was then the lowest level ever. It cut rates, despite the strong growth in the Australian economy because of concern about growing deflationary pressures in the global economy. The bond market believes that we will return to that world once Covid is in the rear vision mirror.
But price inflation could become entrenched in wage inflation
Some people argue that the deflationary force of ageing populations, tech advances, etc. are now much weaker post peak Covid. The bond market clearly disagrees. Other, highly respected, market observers, such as Larry Summers, Mohammed El Erian and Noriel Roubini believe that the bond market is underestimating the persistence of inflation. They point especially to the tightness of labour markets and the likelihood that inflation will become entrenched in wage rises.
It is generally agreed that if Summers, El Erian and Roubini’s predictions about wage inflation turn out to be right, then the US Federal Reserve and Australia’s RBA will have to take their short-term benchmarks well above the inflation rate to slow the economy, suppress wages and bring inflation back to below 3%.
To flesh out that scenario, if price increases and wage increases fed off each other and became entrenched at above 3-4%, then the RBA would have to take the cash rate to 4-5% or more, and variable mortgage rates would go to 6.5-7%. That unattractive prospect is not as likely as the bond market’s expected scenario of inflation falling back quickly, but it is a real possibility, nonetheless.
How to decide
Choosing between a variable or a fixed rate mortgage in the current circumstances comes down to whether the homeowner or investor can manage a much higher interest rate if that occurred. If variable rates going to 6% would cause them real distress, then they should fix today.
Otherwise they should stick with a lower floating rate but keep an eye on whether wage increases are causing inflation to become entrenched.
There is a lot more to discuss here. I didn’t mention what will happen to bank margins (how much banks charge in interest over their cost of funding) which is an important question as the RBA unwinds quantitative easing (QE) and then the Term Funding Facility (TFF). And, we didn’t discuss whether fixed rates are likely to head up in the near future. We will get to those questions in another newsletter.
Copyright 2022 Sam Wylie
A shortened version of this article first appeared in the AFR on 1 June, 2022