The Next Bet on Interest Rates

The Reserve Bank has stated it has a low tolerance for a slower return of inflation to its target band.

Interest rate movements are difficult to predict.

The Reserve Bank (RBA) board will meet again on Tuesday 7 November to determine its next rates move – once again on the same day millions of Australians will tune in to watch the annual running of the Melbourne Cup horse race.

The RBA was already in full stride on raising rates by this time last year, and on 2 November 2022 it lifted the official cash rate by 0.25% from 2.60% to 2.85%, by then the seventh successive rise since it began hiking rates in May last year.

There have been another five rate rises since then with the last, a 0.25% increase to 4.10%, announced in early June this year. The RBA has held rates at that level over the last four monthly meetings.

Whether the RBA raises or holds rates on Melbourne Cup Day this year is an each-way bet. But the case for further rate hikes remains strong.

The latest Australian Consumer Price Index data (released on 25 October) shows inflation rose 1.2% in the September quarter, and the annual inflation rate was at a still-high 5.4%, well above the central bank’s 2%-3% target range.

RBA Governor Michele Bullock drew attention to ongoing inflation shocks when she addressed the Australian Financial Security Authority (AFSA) summit on 18 October, noting that current conditions risk keeping inflation, and interest rates, higher for longer.

The RBA’s October board minutes, also released on 18 October, indicate that the central bank will raise the cash rate again if inflation does not appear to be moving lower at a quick enough pace.

“The board has a low tolerance for a slower return of inflation to target than currently expected,” the RBA’s monthly minutes stated. “Whether or not a further increase in interest rates is required would, therefore, depend on the incoming data and how these alter the economic outlook and the evolving assessment of risks.”

More hikes to come

Vanguard’s Senior Economist Asia-Pacific, Alexis Gray, says the RBA will need to make another one or two more 0.25% rate hikes, which will lift the cash rate to 4.35% or 4.6%.

“We expect headline inflation to fall to around 4.5% by the end of 2023, as higher interest rates work to dampen demand, and to the RBA’s target band of 2%-3% in late 2024 or 2025,” she says.

The prospect of higher rates brings with it the promise of higher monthly repayments for many borrowers, especially mortgage holders with variable interest rate loans.

But the biggest repayments shock is yet to come for mortgage holders who still have fixed-rate loans charging just 2-3% per annum interest. Most of these loans were taken out when rates were at record lows in 2020 and 2021.

For example, two-year fixed-rate mortgages as low as 2% were available to borrowers in November 2021, and three-year fixed-rate loans around 2.50% were on offer in November 2020.

These fixed-rate loans will expire next month, meaning many borrowers will need to refinance their loans at variable or fixed rates averaging 5.60% to 5.90%.

These borrowers are regularly referred to as being on the edge of the fixed-rate mortgage cliff.

A borrower with a $500,000 mortgage (over 25 years) currently with a low fixed-rate loan of 2% will see their monthly repayment jump from around $2,100 to $3,100 (assuming they move to a 5.60% variable rate) once their fixed loan expires.

Gray says the impacts of high inflation and rising interest rates are already being felt across the Australian economy, and rising mortgage rates have an almost immediate impact on spending levels across many households.

“Every time rates go up, if you have a variable mortgage, it gets worse the higher rates go,” she says. “In terms of how that feeds through to the economy, it happens fairly quickly because as soon as your mortgage payment moves your disposable income is reduced.

“But also there’s a sentiment effect, which is that if you know rates are going higher and potentially not coming down soon, you start to delay your purchases. So, people’s psychology shifts quite early in the cycle.

“You can already see from the data that households have tightened their belts, because they don’t have the same disposable income.”

Silver investment linings

While the current higher rates are inflicting financial pain on many borrowers, the flip side is that household wealth is continuing to increase.

Australian Bureau of Statistics data released in September covering the three to months to 30 June shows that average household wealth rose for the third successive quarter, fuelled by increases in residential land and dwelling prices. Population growth is supporting strong demand for housing.

Superannuation assets also contributed 0.3 percentage points to the June quarter’s household wealth growth, with balances supported by stronger share markets performance, higher employer contributions in a strong labour market, and a seasonal increase in post-tax contributions.

Meanwhile, higher interest rates have also translated into higher savings deposit rates and higher yields on new bond investments, which continues to drive strong investor inflows into fixed income securities including exchange traded funds (ETFs) that invest in bond issues.

Australian Prudential Regulation Authority data shows households had around $1.4 trillion of deposits with authorised deposit-taking institutions at the end of August, the majority of which ($1.02 trillion) were held with the country’s four largest banks.

This money pot includes large deposits held in mortgage offset accounts, which many households (including those currently on low fixed-rate mortgages) have available as a savings buffer to fund higher mortgage payments and other general living expenses.

“There are signs that the labour market is turning, but the labour market is still very tight and that’s putting pressure on wages,” the RBA governor told the AFSA summit.

“It’s a real balance here at the moment. Some people are hurting, consumption is slowing, and at the same time you’ve got these other factors which are potentially keeping inflation a little bit sticky and a little bit elevated.”

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Disclaimer: The information (including taxation) in this website does not consider your personal circumstances and is of a general nature only – unless otherwise stated. You should not act on the information provided without first obtaining professional advice specific to your circumstances.

The above material has been reprinted with the permission of Vanguard Investments Australia Ltd.