How the Fed rate hike feeds into your mortgage



Is it good or bad news for Australia that the US has finally started raising interest rates for the first time in nearly a decade? The answer is to be found in recent developments in our economy.

The Australian economy is undergoing a huge structural transformation, shifting a large part of economic activity from mining investment into residential construction, and finally (hopefully) into a new range of export industries.

The middle phase of that process, the ‘housing construction boom’, is ending very rapidly.

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As reported earlier this week, the federal Treasury has halved its forecast of growth in that sector, which means other sectors had better get moving if we are to avoid a jump in unemployment.

But there is a second troubling part to our reliance on the housing construction boom, and that’s in relation to Australia’s private debt problem.

Now, many voices in the media are saying that our world-beating addiction to mortgage debt is not a problem at all – from RBA governor Glenn Stevens to the real estate and banking industries, there is no shortage of people wanting to tell us that as long as our assets are increasing in value, then historically high levels of debt secured against them aren’t a problem.

Really? The obvious retort is that some housing markets are already falling in value – Perth and Darwin are the worst – and there could be substantial price falls in bubble cities Melbourne and Sydney in the next year or so.


Federal Reserve Board Chairwoman Janet Yellen holds up a copy of the Federal Reserve’s 100th Annual Report. Photo: Getty

That is not a firm forecast, but just a statement of the obvious downside risk in an economy where wages are barely growing, but our record private debt levels are still growing strongly.

The other problem with the ‘debt is good’ story is the question of where the money comes from – and that’s where the Fed’s decision to raises its target ‘Fed Funds’ rate to a range of 0.25 to 0.5 per cent starts to look like bad news for Australia.

In the past few decades, Australia has been more reliant on overseas wholesale funding markets for its mortgage funds than comparable developed nations.

While nations such as France, Germany and Japan source about 20 per cent of their housing debt on wholesale markets, Australia’s exposure is typically 30 to 40 per cent.

When banks raise money by issuing bonds in foreign currencies, they hedge the debt so that a three-year bank bond, for instance, is worth the same amount in Aussies dollars when it has to be paid back.

That eliminates currency risk, but does not affect the price the bank sells the bond for in the first place.

Hypothetically, if there is strong demand for bank bonds, investors will pay a high price for each bond – let’s say 90 cents for every 100 cents of face value of a three-year bond.

That means that when the bank pays the bond holder back the face value of 100 cents after three years, the effective ‘interest’ they are paying is around 3.5 per cent per year.

However, if investors have better options elsewhere, demand for Aussie bank bonds will be weaker.

That could mean, for example, that the bank sells three-year bonds for 88 cents for each 100 cents of face value. When the bond is redeemed, the bank would therefore be paying an effective interest rate (or ‘yield’) to the investor of nearly 4.5 per cent.

Until quite recently, Australian banks enjoyed several years of strong growth in their mortgage businesses, with the total amount lent rising rapidly in line with soaring house prices, particularly in Sydney and Melbourne.

Banks were trying to grab market share, lending huge sums to property investors – or they were, until the Australian Prudential Regulatory Authority put an end to the party by imposing much stricter capital reserve and lending requirements on them.


Traders in the Standard & Poor’s 500 stock index options pit in Chicago react to the Federal Reserves interest rate hike. Photo: Getty

There are early signs that those macro-prudential measures are working, and that the big four banks in particular are beginning to simply roll over debt, rather than expand it.

But rolling over long-term debt means paying today’s bond prices. Global debt markets are still very cheap, but the prognosis coming out of the Federal Reserve this week is for steadily rising costs.

The Federal Open Markets Committee – the body that decides what level to set the target ‘Fed Funds’ rate in the US – has indicated that up to another 100 basis points of interest rate tightening will occur during 2016.

If that comes to pass, US rates will have moved from a range of zero to 0.25 per cent, to 1.25 to 1.50 per cent in just over a year.

Those ‘overnight’ interest rates ripple through bond markets, and debt is repriced across the board, including longer-term debt, to reflect this monetary tightening.

Tough times ahead for Australian homeowners

What that means for Australian mortgage holders is yet another source of out-of-cycle interest rate rises.

During 2015 owner-occupier borrowers have been hit with out-of-cycle rate rises that reflect APRA’s tightening of capital adequacy rules of banks. And investor borrowers, who also copped that interest rate increase, paid even more for their money due to APRA’s investment lending clampdown.

So on top of that, the rising cost of wholesale funding may start to bite.


Will the US interest rate hike be good or bad news for our dollar? Photo: Shutterstock

Stephen Koukoulas, principal of Market Economics, points out that because we’re mainly talking about three-year or five-year money, there will be a time lag – he sees the higher cost of money possible starting to show up by the end of 2016, or certainly in 2017.

That could be an awkward time for Australian households.

The Aussie dollar, which is now at 72 US cents, down from a peak of around 105 US cents, is making our exports cheaper, but imports more expensive. That effect is being masked to an extent by very low oil prices.

However, by the time higher borrowing costs abroad start to filter through to households, there is every chance oil will be rebounding. Households will be dealing with a higher cost of living, higher mortgage rates, and all paid for with stagnant wages.

Overall then, the early move to normalise rates in the US is good news for the global economy – a gradual ramp up in borrowing costs should return a number of inflated asset markets to more reasonable valuations.

But Australia’s record private debt stock, most of it in the form of mortgages, means we will be ultra-sensitive to higher borrowing costs. Moreover, Australian residential property looks likely to be on that list of deflating asset classes around the world.

The Fed has done the world a favour, but Australia has not done itself any favours by becoming a debt-heavy, housing-reliant economy.

Read more columns by Rob Burgess here


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