Why the risk of out-of-cycle mortgage rate increases is rising in Australia, in one chart

ANGELOS TZORTZINIS/AFP/Getty Images
  • The RBA hasn’t moved official interest rates since August 2016.
  • Short-term Australian money market rates have spiked, creating margin pressures for banks.
  • Some smaller Australian banks have already announced increases in variable mortgage rates due to funding pressures.

The Reserve Bank of Australia (RBA) hasn’t moved official interest rates since August 2016, delivering a cut of 25 basis points to the cash rate, leaving it at its present level of 1.5% since then.

If the vast majority of economists and traders are on the money, the cash rate looks set to remain steady well into next year, perhaps longer.

Already at 20 meetings, this record stretch of policy inaction looks set to get a lot longer yet.

Given that outlook, it’s understandable why borrowers may become complacent that their mortgage interest will also remain the same.

The RBA sets interest rates, and if it’s doing nothing, my borrowing costs will remain the same, right?

Not quite.

While the RBA sets the overnight cash rate, financial markets determine borrowing costs further out the yield curve.

The cash rate is essentially an anchor, setting a starting point for what borrowers pay longer-term.

Factors such as creditworthiness, the duration that money is being lent for and the outlook for inflation are all factored taken into consideration to determine the price of money.

That point brings us to the excellent chart below from Macquarie Bank.

Macquarie Bank

It shows two things.

The first, in black, is the spread between the RBA cash rate to the average discount variable mortgage interest rates in Australia.

The second, in red, is also an interest rate spread, only this time between the RBA cash rate and the three-month bank bill swap rate (BBSW), the price banks lend to each other at for three months on an unsecured basis.

A couple of interesting talking points come from the chart.

For one, the spread between the cash rate and mortgage rates has widened substantially since the GFC, lifting from around 120 basis points to around 300 basis points today.

Also of note, when money market rates have spiked in the past, it often leads to a widening in the spread between the cash and mortgage rates for borrowers.

While that was seen during the GFC, European debt crisis and, more recently, concerns over the Chinese economy in late 2015 and early 2016, short-term money market rates have been on the rise recently, hitting levels not seen since Europe was on the cusp of economic Armageddon.

Although no one factor can explain the recent increase, few, if any, believe it’s a sign of credit risk.

However, that’s not to say it won’t have any implications.

Just as it has in the past, higher funding costs for banks means the risk of out-of-cycle mortgage rate hikes is increasing, especially if they stay at current levels, or higher, for a considerable period of time.

Bank margins are being pressured, meaning they can choose to absorb the cost or pass it on to end-borrowers.

While some believe the Banking Royal Commission in Australia will see many lenders take the first approach, choosing instead to take the margin pain given the potential political and regulatory ramifications, not everyone agrees.

Indeed, in response to margin pressures, some smaller Australian banks have already announced that they will lift variable mortgage rates, even with the RBA on hold.

If they are being impacted, and have decided to pass on the increased cost to their borrowers, what’s to say larger banks won’t do the same in the not too distant future?

It is clearly a risk.

Earlier this month, the RBA Board suggested that “slightly higher funding costs for banks appeared to have had little effect on mortgage rates”.

However, given recent market moves, perhaps that view will soon need to change.

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