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Interest rate outlook

Good news about Australia’s economy has brought out some concerns about interest rate rises. Should borrowers start worrying? To get a sense of how someone at the pointy end of the banking game is thinking right now, ING’s chief investment officer Glenn Baker joins Peter Switzer.

Baker says the Reserve Bank is sending out a “very clear message” that the current cash rate, which is at a 49-year low of three per cent, has done its job.

“Given that we’re not going to have the kind of recessionary conditions we expected, they are now sending a very clear signal that rates are going to go up next as opposed to down,” he says.

Predicting when interest rates are going to move is difficult, but Baker say the RBA is balancing a couple of risks: if they move too early, it could hurt the recovery, but if they leave it too low for too long, it may encourage inflation later on.

“Popular opinion is now that we’re probably only a couple of months away from the first move,” he says. “But I think it will be a measured move, like a 0.25 per cent change, so it’s not going to take off in the same way they came down sharply.”

Rates back to normal

Baker says the expectation is rates will go to back to what is considered normal, around five to six per cent, in a “reasonable” amount of time, which could mean a year or 18 months, not a few months. It is expected rates will go up, “but don’t expect them to go up in big jumps”.

What does this mean for the banks?

“There’s definitely pressure in all banks in terms of the cost of borrowing money to support their businesses,” he says. “And that’s the reality because the debt markets are still asking for quite high rates in terms of borrowing, so as older liabilities in banks mature and new ones come on, it actually ratchets up the overall weighted average cost of money. So, it is a reality and it’s likely to happen.”

Switzer says with money that was borrowed three or five years ago, as it matures it was on a much lower rate than it is now, so therefore the average cost of borrowing is going up. Will three-year money or five-year money be for fixed home loans, or could it also be used for variables home loans which are supposed to go for 20 years? How do banks juggle their money? Baker says some of it will be directed towards fixed loans, “but in general banks are going to run a liquidity profile that’s as strong as they can make it without incurring too much cost”.

This means some of the funds will be supporting variable mortgages too.

“[Banks] can’t borrow in the overnight market to support a variable rate mortgage, so [they] have to borrow term money,” he says. “And you have to take the spectrum of borrowing across all those maturities and look at what the weighted average is and that’s what happening. Some of the older funds will come off, but the new ones are coming at higher rates.”

So when will banks move their rates? Banks have been saying the cost of funds pressure is building, Baker says, “so there is a possibility they could do it without a Reserve Bank move.”

More competition

Baker says ING hasn’t securitised to fund themselves as they are a double A-rated bank and have been able fund themselves in the marketplace, but they have done securitisation for liquidity support purposes, which the Reserve Bank now accepts, say Baker.

“One of the issues for competition at the moment is that the government guarantee is in place for wholesale debt market borrowings, and there’s a different fee structure depending on the rating of your bank,” he says.

Double A-rated banks can borrow at a lower rate. He says double A-rated banks borrow at a 70 basis points, or 0.7 per cent, fee, but lower rated banks can pay up to 1.5 per cent. He says this is not “a level playing field” and if the government were going to do anything, it may be to try and create one.

“On that point, and talking about securitisation markets, there’s been a lot of discussion about covered bonds, which is where you’d have a normal looking bond issued by a bank, but supported by the underlying mortgage securities,” he says. “They could be issued and be triple A-rated – it’s not a securitisation, so you need a balance sheet to do it – but it would take away this anomaly of an unlevel playing field between the guarantee fees.”

Banks like Bendigo or Suncorp-Metway, which are not double A-rated, pay more to borrow at the moment. A covered bond would mean this type of lender could borrow at a lower rate, which would make them more competitive with the big four banks, and ING, which are borrowing at lower rates because of their double A-rating.

“That’s the fundamental, that everyone has mortgage securities they could use to create a covered bond with and they’d be pretty well similar securities in terms of the mortgages in their books, so therefore you’d expect that the borrowing costs would be similar once you did that,” he says.

So what does the government need to do for a covered bond to work? Baker says there has been an issue with the Australian Prudential Regulation Authority (APRA) in that they won’t allow banks to use covered bonds because “it’s anti the banks act in terms of deposit or protection provisions”. For it to happen, the government would need to change the banking act.

And finally, Switzer asks where Baker thinks interest rates will be two years down the track. Baker says RBA’s Glenn Stevens is saying at the moment that rates have to return to a normal level. 

“So I’d pick somewhere between five and 5.5 is where the cash rate would be then,” says Baker. “And that will translate to a mortgage rate that’s two to 2.5 per cent above where it is now which is seven to 7.5.”

Book a complimentary first appointment with Switzer Financial Services today. 

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice. 

Published on: Wednesday, September 16, 2009

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