The only way is up: Markets bet on a hefty rise in interest rates

Economy

In recent weeks, an arcane part of the financial markets has been signalling mortgage rates may rise much more sharply than many would have expected a few months ago.

Fretting about rising inflation, traders have placed bets the Reserve Bank’s cash rate will go above 3 per cent in 2024. If the market is right – and that is a massive “if” – it would be a hefty increase, which would add hundreds of dollars to monthly repayments on the average mortgage. The current cash rate is just 0.1 per cent, and it hasn’t been at 3 per cent for nine years.

Markets are pricing in a cash rate of 3 per cent in 2024. Credit:Peter Rae

It’s also a major change from late last year, when markets were pricing in a peak cash rate of about 2 per cent by 2024 (which would still be a pretty significant increase in its own right).

What’s prompted these bets of a much higher cash rate? What would hikes of this size mean for borrowers? And wouldn’t rates this high risk harming consumer spending?

The main reason interest rates are back in the news is inflation, which has risen especially sharply in the United States, prompting the Federal Reserve to raise its interest rate in March.

It’s too simplistic to assume the RBA will automatically follow the Fed. Indeed, RBA governor Philip Lowe has stressed he will be “patient” and won’t raise rates until inflation and wage growth are higher in Australia.

But equally, Lowe will need to lift the cash rate from 0.1 per cent at some stage to keep inflation in the bank’s 2 to 3 per cent target band, and he has recently conceded a rate increase this year is “plausible”.

So, the key question is not whether rates will eventually rise, but rather by how much. Forecasters in the banking world are divided on this question.

At one end of the debate, Commonwealth Bank economists think the cash rate will only need to go to 1.25 per cent by next year to achieve the RBA’s objective because this would take mortgage repayments to their long-term average of about 15.5 per cent of household disposable income.

ANZ Bank economists are taking a different view, predicting the cash rate will eventually go above 3 per cent, though not until about 2025.

These forecasts might turn out to be wrong, just like those dire predictions many economists made of a COVID-19-driven property market meltdown in 2020.

But whoever is right, the hefty size of the average mortgage these days means that rates don’t have to move by all that much to have a sizeable impact on monthly repayments.

For example, RateCity calculates that a 1.75 per cent peak in the cash rate by 2024, as forecast by Westpac, would add $431 onto the monthly repayments for a $500,000 loan. If ANZ’s call is correct and the cash rate goes to 3 per cent by 2025, repayments on a $500,000 mortgage would rise by a whopping $771 a month.

Wouldn’t these sorts of increases force households to rein in their budgets, threatening to slow the economy?

Yes, but that is the whole point of raising interest rates: it dampens activity, and inflation.

At the same time, however, banks are confident the vast majority of their customers will cope with higher rates.

For one, they point out households are sitting on a massive savings pile of about $250 billion, much of which is in mortgage offset accounts, allowing people to pay down debt faster. When rates rise, borrowers will probably find it tougher to pay back debt quite so quickly.

Banks – which stand to benefit from higher rates – also say borrowers have been “stress tested” against higher rates as part of being approved for loans.

Finally, it’s worth remembering that if inflation is rising, wages should also be increasing, making it easier to repay debt. At least that’s the theory.

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