How the RBA will react to the changing face of the mortgage market

Mortgage borrowers seem to have come to the conclusion that interest rates are unlikely to stay at such low levels indefinitely. And that they would be well advised to freeze those rates while they can.

“The share of fixed rate loans is increasing,” report economists at the Commonwealth Bank. “About half of all homeowner loans were fixed rate in April.

“Fixed rate loans accounted for about 45% of investor loans during the month.”

And, of course, the sharp rise in house prices has been accompanied by a corresponding increase in the average home loan amount.

“The average amount of loans has skyrocketed in recent months,” said economists at the Commonwealth Bank. “Rising house prices mean buyers generally have to borrow more than before.”

Of course, the growing popularity of fixed-rate loans – which traditionally represent only around 15% of mortgages – itself reflects the emergency monetary measures that the Reserve Bank adopted last year to protect the economy. economy from the devastation caused by the coronavirus pandemic.

In order to ensure a plentiful supply of cheap financing for businesses and households in the country, the Reserve Bank authorized banks in the country to borrow $ 200 billion over three years at the ultra-low rate of 0.1%.

And to underscore its commitment to keeping interest rates extremely low for an extended period, the Reserve Bank adopted a new three-year bond yield target of 0.1%.

Armed with a plentiful supply of super-low-cost finance, the country’s major banks have embarked on a relentless effort to increase their share of the attractive mortgage market – where their levels of problem loans have remained low, despite the disruptions. economic effects caused by the pandemic.

But, as the economic recovery became more vigorous, the Reserve Bank began to cut some of its emergency monetary support.

He has previously announced that banks only have until the end of June of this year to access the remaining $ 100 billion in cheap three-year funds remaining under the term finance facility.

And most economists expect the Reserve Bank to take the April 2024 bond as a target for the three-year goal, rather than pushing it over to the next maturity, the November 2024 bond.

Economists expect that this slight decrease in monetary stimulus will eventually translate into a modest rise in long-term bond yields in wholesale financial markets, which in turn will lead to higher interest rate lending rates. fixed.

Real challenge

And that should provide further relief to the extremely hot residential real estate market. Already, the pace of price increases appears to have eased, with buyers increasingly aware that lower borrowing costs won’t last forever.

But, of course, the real challenge for the legions of indebted home loan borrowers will come when the Reserve Bank raises its official cash rate, which is currently at the historic low of 0.1%.

The Reserve Bank has continuously sought to allay this concern, stressing that it will not raise official interest rates until it is certain that real inflation is permanently within its target range of 2 to 3%.

For this to happen, the labor market would have to tighten considerably, to spur much stronger wage growth. The Reserve Bank believes this should not happen until 2024 at the earliest.

But market participants believe the Reserve Bank is unduly pessimistic about the strength of the economic recovery and the outlook for inflation. Indeed, market prices indicate that official interest rates will likely reach around 1% by 2024.

Regardless of the timing, when the time comes for the Reserve Bank to start raising official interest rates again, the central bank will have no choice but to consider the changes in the mortgage market.

First, the Reserve Bank will have to take into account that people have increased their borrowing levels. This higher debt burden means that any increase in official interest rates will have a more dampening effect on consumer spending than before.

At the same time, however, the growing share of fixed rate loans means that the rise in official rates will be slower to have an effect on overall economic activity.

This is because people who are stuck in fixed rate mortgages will not have to raise repayments even if official rates rise.

Yet while immune to the immediate impact of higher official rates, mortgage borrowers are likely to be keenly aware that their loan repayments will eventually increase when their fixed rate loan comes to an end. and they will have to renew it at a higher rate.

And of course, that could be a considerably higher rate than what they’ve already paid on the ultra-low fixed-rate home loan they took out in the wake of the pandemic.

And that will be another factor the Reserve Bank will need to weigh carefully when it comes to future rate hikes.

When it comes to rolling over their fixed rate loan, borrowers will not simply be faced with an increase in official interest rates from the Reserve Bank. Instead, they will be faced with the entire increase in borrowing costs from the time they first take out their loan.

Borrowers from non-bank mortgage lenders will also feel the spur of rising interest rates as the Reserve Bank begins to reduce its emergency monetary support.

This is because non-bank lenders have been the indirect beneficiaries of this support.

The Reserve Bank’s $ 200 billion term financing facility meant the country’s banks did not need to raise funds by issuing asset-backed securities.

But non-bank real estate lenders quickly took advantage of banks’ absence from the market to ramp up their own issuance of residential mortgage-backed bonds. And they were able to borrow at very attractive rates.

As the Reserve Bank’s Monetary Policy Statement notes, “Residential Mortgage Backed Securities (RMBS) spreads have narrowed significantly for non-banks and banks in recent months, falling sharply. below pre-pandemic levels ”.

Indeed, the press release notes that “spreads on RMBS are at their lowest level since 2007”.

According to the statement, “Market comments suggest that low levels of bank bond issuance are contributing to these low spreads, as investors turn to other securities, including RMBS, seen as substitute investments for bank obligations “.

The author owns shares in major banks.

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Alan Adams

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