Cash rates and mortgage rates

At 2.30pm this afternoon, the Reserve Bank of Australia (RBA) will announce whether or not they will be changing the official cash rate. The bank began increasing the cash rate just over a year ago and since then it has risen by 1.25% to its current level of 4.25%. Most observers in the financial markets expect the RBA to lift the rate another 0.25% today, pointing to last week’s inflation figures as one of the key factors. One of the RBA’s stated objectives it to attempt to maintain “an inflation rate of 2–3 per cent, on average, over the cycle”. That phrase “over the cycle” gives the bank a fair amount of wriggle room, nevertheless it will certainly be concerned that the inflation rate for the March 2010 quarter was 0.9% (or 3.6% on an annualized basis). The RBA uses a number of smoother measures of inflation that aim to strip out some of the volatility in the headline inflation numbers. One of these, the “trimmed mean”, is widely considered to be one of the bank’s favourite smoothed measures and the March quarter reading has now nudged outside the 2-3% target band.

Australian Inflation (2003-2010)

However, the point of this post is not to speculate on the likelihood of another rate hike, but to respond to a query from a reader about the link between the RBA official cash rate and mortgage rates.

In Australia, most home owners have “variable rate” mortgages, so their interest rates can go up and down over the life of the mortgage. It is possible to lock in “fixed rates”, although typically the fixed rate periods only last from between 1 to 5 years. In contrast, the most common mortgage product in the United States is a 30 year fixed rate mortgage, which certainly takes away a significant element of risk for borrowers. An indication of just how significant this risk can be is evident in the fact that the US “sub-prime” mortgages at the heart of the global financial crisis were not fixed rate mortgages and big increases in interest rates tipped many borrowers into default.

The United States aside, variable rate mortgages are very common around the world. What is rather unique to Australia is the way in which rates can vary. In most countries, variable rates are set relative to a standard published benchmark. Since the point of a variable rate is to allow lenders to increase (or decrease) what they charge borrowers as their own short-term borrowing costs change, these benchmarks are typically short-term market rates such as surveyed inter-bank lending rates (typically a 1 month or 3 month rate) or perhaps the official central bank cash rate. These central bank rates apply to very short-term borrowings, typically applying for somewhere between one day and one week (for example, the RBA cash rate is an overnight rate), but have the advantage of not moving around too often. A mortgage-lender might then quote their mortgage rate as, say, 2% over the benchmark rate.

In Australia, things are a little different. The standard variable rate is a so-called “discretionary variable rate”. Put simply, this means that the rate can be whatever the lender wants it to be. Try explaining that to anyone from another country and they would be horrified (I can speak from experience here), but in Australia we seem to have become accustomed to giving all this discretion to our lenders. The usual justification for this approach is that competitive pressure would stop a bank abusing the power inherent in that word “discretionary” and in practice all the banks move their rates in line with the RBA cash rate anyway.

Of course, since the onset of the global financial crisis put pressure on funding costs for banks, this link between the official cash rate and mortgage rates has broken down. Back when the RBA was cutting rates, banks were cutting mortgage rates by less than the RBA cut and, on the way back up, they have been hiking in bigger increments than the RBA*. Some have even increased rates “out of cycle” (i.e. independently of the RBA cash rate movements). Once upon a time, the then Treasurer Peter Costello said that any bank not passing on an RBA cut in full was a “bastard”. Things are different now and if the RBA does indeed increase rates today and you have a mortgage, do not be too surprised if your mortgage rate goes up by even more. If you don’t have a mortgage, try not to gloat. It is unseemly.

* UPDATE: as noted in the comments below, the RBA has estimated that mortgage rates have increased by around 1.3-1.4% more than the official cash rate.

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10 thoughts on “Cash rates and mortgage rates

  1. Senexx

    If I remember correctly 4.5% is what Saul Eslake approximated the new ‘neutral’ rate was going to be post-GFC.

  2. Stubborn Mule Post author

    Senexx: one argument that rates will not go much higher is that, while the cash rate is still below average levels, according to the RBA mortgage spreads to the cash rate are about 1.3-1.4% higher in the wake of the global financial crisis (the result of those extra hikes I wrote about in the post). So, even if official cash rates are below average, mortgage rates are closer to some sort of average level (business lending rates have also increased more than the official rate) which means that the RBA may feel they do not have to raise rates as high as they have in the past.

  3. Danny Yee

    A question for the fixed interest gurus. How is the RBA OCR related to the yield on government bonds? Is it as simple as the OCR providing the starting point for the bond yield curve?

    I notice the yield on 10 year bonds dropped 4 basis points yesterday, presumably following the stock market down.

  4. Stubborn Mule Post author

    Danny: the relationship between government bond yields and the overnight cash rate (OCR) is not that simple. Although the RBA targets the OCR, it is in fact an inter-bank rate. While the change of a bank defaulting over a 24 hour period may seem low, it is still riskier than a government security. The tricky thing is that one-day government securities are not available. You can look at repo rates (which are loans with government securities as collateral) and overnight repo rates are typically below the OCR. You can also look at short-dated Treasury Notes (which have been issued again since March 2009 after stopping at the end of 2002). Unfortunately the water is muddied by the term structure between overnight and the maturity of the T-Note. But, as an example, on the 4 March T-Note tender, a 3 month T-Note was issued at an average yield of 3.973%. On that date, the OCR was 4% and, since markets have been expecting the cash rate to go for some time, a 3 month rate would be higher still. So, the starting point of a theoretical government bond yield curve starts below the OCR.

    As for the 10 year bond yield move yesterday, while I wasn’t watching the market yesterday, it would not have been linked to the stock market (which itself was affected by the falls in resources stocks following the release of the Henry report and the government’s indication they would impose a resources tax).

  5. Danny Yee

    Thanks, that makes sense.

    Are you sure bond prices aren’t linked to the stock market, though? There seems to be a pretty strong (negative) correlation to me, though I haven’t done any proper data analysis.

  6. Stubborn Mule Post author

    Danny: a simple dividend-discount model would imply a negative correlation (higher rates mean bigger discounting of future dividends). However, there’s also the relationship between earnings growth itself and interest rates to think of. In broad terms, in business-cycle downturns, equities tend to fall and so to interest rates. The relationship between interest rates, inflation and equity performance is another angle to consider.

    However, my earlier comment was more a reflection of what happened yesterday than on the broader relationship between interest rates and equities.

  7. Surya

    Hi Sir,

    Very Interesting post,

    How would you predict the Yield Curve to change over the next month? and also what shape would you predict for this yield curve.

    My second question is, what is the real relationship between the CASH Rate, and Government Yields (i.e. the relationship between the cash rate and the treasury yield curve).

    My final question is, in these times of rising interest rates, where do investors turn? Debt (Bonds) or equity (stocks), and by doing so how does this impact on the yield curve?

  8. Stubborn Mule Post author

    Surya: predicting movements in the yield curve is tough. While the yield curve should provide a measure of future movements in the cash rate, it is the market’s expectation so you face Keyne’s beauty contest challenge. You are not so much trying to predict future movements in cash rates but predict what the market thinks cash rates will do.

    As for the relationship between Government bond yields, there is one. Very short-dated Government securities (Treasury Notes) tend to trade at a yield a little below the cash rate. So, in principle, longer dated yields reflect the market’s forecast of a the cash rate…less a bit.

    The relationship between equities and interest rates can be tricky too. A simple argument would be that higher interest rates should be bad for equities either because you are discounting future earnings more or, equivalently, because corporate funding costs are going up. On the other hand, that assumes that earnings forecasts do not change. If interest rates are going up because the economy is getting stronger and/or inflation is on the rise, then that could be associated with increased earnings. Which effect will be greater? Hard to say!

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