Are interest rates on fixed rate loans going to rise or fall over the next year? Should investors fix the rate on their investment loans while rates are low?
A good starting point in thinking about Australian interest rates is to look at the $A Treasury yield curve. It shows shows the interest rates at which the Australian Federal Government can borrow money over different lengths of time. Those ‘Treasury’ rates are ultimately the benchmark for the rates at which every other party in the economy – households, firms, banks, everyone. – can borrow. The current $A yield curve is shown below.
Figure 1: The $A Treasury yield curve on 30 January 2015
Shape and level of the yield curve
The yield curve is at an historically low level. Investors who lend money to the Federal Government for 3 years (hold Treasury notes with 3 years to maturity) are only getting a 1.97% yield on that lending. Even for 10 year lending investors are only getting 2.48%.
Note that only one interest rate in the yield curve is set by policy. The interest rate on the far left hand side is the overnight Cash Rate that is set by the RBA. The Cash Rate is currently 2.50%. The RBA can move the left hand side of the yield curve up and down at will. But all the other interest rates on Government debt are determined by supply and demand for the corresponding Treasury notes (less than 10 years to maturity) and bonds (maturity of 10 years or more).
The high demand for medium term notes (of 2-5 year maturity) is causing their yields to fall – investors must accept lower yields (or equivalently pay higher prices) to get their hands on the notes. But the left hand side of the curve is fixed, so the yield curve slopes downwards at the left (it is inverted). Inversion of the yield curve is unusual, happening only 10-12% of the time. Historically, it has been a strong indicator that the economy is heading into recession. So, inversion of the yield curve is usually followed by a cut in the Cash Rate (which unwinds the inversion).
Why is demand for Australian Government debt so high?
The demand for Treasury notes has risen for two reasons:
Fear: We live in uncertain times and investors value the risk free nature of Australian Treasuries. Treasury notes are the most defensive of long term investments. Preservation of capital and receipt of promised income is guaranteed. If all else failed the Federal Government could pass legislation that ordered the RBA to print money to make the payments on the bonds. As the fear level rises Treasury yields fall.
Note that household investors have an alternative to 3 year bonds – they can take out 3 year bank term deposits and receive a full government guarantee over the life of their deposit (up to $250,000 per person, per bank). That level of protection is too small to help superannuation funds, insurance firms and other institutional investors.
Expected inflation: Bonds are protection against deflation because the real value of the promised interest and principal payments increases with falling inflation. Deflation is the friend of lenders (bond holders) and the enemy of borrowers, and inflation is the reverse. I can’t emphasise that enough. Inflation is falling all around the world and Australia is not immune. Falling commodity prices will draw the pall of deflation into Australia’s open economy. The shape of the yield has imbedded in it the markets’ expectations about changes to short term rates (and inflation). The fact that short term rates are higher than medium term rates means the market expects short term rates to fall. If that was not true then investors would sell their 3 year notes today and buy 1 year notes. The market is only locking in a rate of 1.97% for 3 years because it expects the Cash Rate to fall even lower than 1.97%.
Fixed rate loans
The low yield on 3 year and 5 year notes is good news for investors who want fixed rate loans. Consider the arithmetic of current 3 year fixed rate bank loans. A 3 year fixed rate of 4.85% has a spread of 288 basis points (bps or “bips”) over 3 year Treasuries. At that spread banks are getting a very high return on equity for the loans they are making and we should expect competition to drive the spreads on fixed rate loans down.
How low could the 3 year fixed rate be driven by competition between banks? Lets say that on a large mortgage banks need their cost of debt funding plus 100 bps to originate and then service the loan and to get a sufficient return on equity. For a three year mortgage that would be:
197 bps Rate at which the Government can borrow for 3 years
+ 100 bps Credit spread to Treasuries for a AA rated bank (conservative)
+ 30 bps Exchange rate hedging for bonds issued in USD
+ 100 bps Servicing and ROE
= 425 bps or 4.25% (approximately)
The assumption here is that if the yield on 3 year Treasuries does not change then competition between banks will drive the interest rate on 3 year fixed rate mortgages down by 60 bps to 4.25%. This is quite a conservative estimate. They might go to 4.00% if there is enough competition.
The US mortgage market differs from Australia in its structure and of course the level of the yield curve. Nonetheless, it is interesting to note that 30 year fixed rate mortgages are at 3.60% in the US. And, for most US states there is no early repayment fee. Floating rate mortgages are currently at 2.40% in the US.
To summarise, there are good reasons for thinking that rates on fixed rate loans will fall before they rise. Some investors will wait for rates on fixed rate loans to fall another 50-70 bps and then lock rates in for a long time.