Borrowers have dodged multiple rate increases

Extreme competition in the banking sector has allowed most borrowers to avoid some of the RBA's rate increases
Christopher Joye

Coolabah Capital

One of the challenges the Reserve Bank of Australia faces is an unusual lack of pass-through from changes to its official target cash rate to actual lending rates, which are ultimately what it is trying to influence. This means policy is working more slowly than expected for a number of obvious and not-so-obvious reasons.

Coolabah’s analysis of the RBA’s data reveals that only 225 basis points (or 64 per cent) of its 350 basis points of total cash rate increases through to March this year have been reflected in a higher average interest rate paid on existing home loans. Put another way, borrowers have been spared about 125 basis points of interest rate hikes in this cycle.

It is well known that the incomplete pass-through of the RBA’s hikes to the average home loan rate on existing mortgages reflects the surge in fixed-rate lending as a result of the RBA providing banks with $189 billion of three-year loans during the pandemic at an incredibly low fixed cost of between 0.1 per cent and 0.25 per cent annually.

This allowed banks to offer borrowers super-cheap fixed-rate home loans, which jumped from about 15 per cent of all mortgage products (the remainder were variable rate) to almost 40 per cent of the stock outstanding by the end of 2021. Significantly, about half of these fixed-rate mortgages will switch to variable rate this year, which means borrowers will have to contend with a huge rise in their annual mortgage rates from circa 2 per cent to 6.5 per cent.

The more interesting development is the incomplete pass-through of the RBA’s hikes to new, rather than existing, variable-rate loans. On our numbers, new variable-rate borrowers have been spared a chunky 50 basis points of the RBA’s total 350 basis points of rate increases. If we examine all variable- and fixed-rate loans offered to new borrowers, the pass-through has been even less at 290 basis points (ie, both variable- and fixed-rate borrowers have dodged, on average, 60 basis points of the RBA’s hikes).

This probably reflects intense competition among banks for new loans, which should give the Australian Competition and Consumer Commission some comfort in respect of ANZ’s pending acquisition of Suncorp Bank.

Indeed, it is the first time in decades – since the 1980s and 1990s – that banks have not passed on all the RBA’s hikes. Since the global financial crisis, banks have usually hiked by more than the RBA’s cash rate changes over the course of the cycle as a consequence of them adding on more expensive funding costs.

The RBA is fully aware of these discontinuities. It is ultimately targeting borrowing rates, and if lenders do not fully pass on its cash rate changes it will continue lifting rates until it secures the practical cost of capital that it wants to see prevailing across the economy.

Balance sheet surprise

It does, however, have another trick up its sleeve. During the week, the RBA published its board minutes, which surprised financial markets with a reference to the fact that the central bank will consider shrinking its balance sheet more rapidly than planned.

After the start of the pandemic, the RBA bought $224 billion of Commonwealth government bonds to push down their long-term yields by about 30 basis points. Recall it had cut its overnight cash rate to close to zero per cent by November 2021, which was a de facto lower bound. Its bond purchase program allowed it to further compress longer-term risk-free interest rates – or the market’s estimate of where the RBA’s cash rate will be over time. This is important for fixed-rate borrowers given that fixed-rate loans do not price off the RBA’s overnight cash rate. The interest rates on these products – relevant to many businesses, governments and households – are determined instead by long-term government bond yields

The RBA had planned for its pandemic bonds to mature off its balance sheet over time in what would be an organic unwinding of the policy known as a “passive taper”. In the board minutes, it revealed that members felt the “large holdings of government bonds exposed its balance sheet to a significant level of interest rate risk” and it would therefore “review the current approach periodically”.

For the first time, this has opened up the possibility that the RBA could embrace a more active as opposed to passive taper of its balance-sheet holdings of Commonwealth bonds by way of regular asset sales, which could ultimately be tantamount to another, circa 30 basis point interest rate increase. (This estimate accords with the RBA’s research on the topic.)

Martin Place might be tempted by this option if it feels it has to tighten monetary policy on a more broad-based basis rather than just relying on its overnight cash rate to do the heavy lifting, which would be similar to the logic it applied during the pandemic.

The RBA might not be the only bank experiencing a downside surprise to its balance-sheet dynamics. Our credit analysts do a great deal of modelling on what the future holds for Aussie banks in this context.

Excess funding

The broad contours are clear: the biggest rate hiking cycle in history is going to crush bank balance-sheet growth. And as the interest rates on deposits soar, banks are likely to find themselves in a position where they are awash with excess funding relative to the actual demand for loans.

Our research shows that if we take the banks’ deposit and loan growth over the past six months and use this as the basis for projecting debt issuance needs over the next three years, the four major banks will need about $157 billion of total wholesale funding, including both senior-ranking and Tier 2 bonds, each year.

That is slightly higher than their long-term historical run rate. Our modelling accounts for the fact that the banks have to repay the $189 billion they borrowed off the RBA. It also assumes the banks maintain very strong liquidity metrics in the face of a range of negative impacts, such as repaying the RBA its $189 billion and bond maturities off the RBA’s balance sheet, which sucks cash out of the banking system. We would venture that the bank treasury teams have similar projections.

Where the numbers get much more interesting is if we instead focus on how the banks’ balance sheets have been growing over the last few months. Among the four majors, loan growth has decelerated from an 11 per cent, three-month annualised pace in July last year to just 3 per cent in March this year. Assuming the last quarter of loan and deposit growth is a better guide to future issuance needs, we find that wholesale funding requirements for the four majors drops dramatically from $157 billion a year to just $109 billion a year.

An alternative benchmark is to consider what played out during the period following the RBA’s last hiking cycle between 2009 and 2010. Using the experience of the banks’ loan and deposit growth over 2010 to 2012, our analysis suggests that the majors’ issuance needs could eventually decline to as little as $89 billion a year as the demand for savings climbs while loan growth deteriorates.

This contrasts strikingly with both bank treasury and sell-side analyst estimates for issuance of about $140 billion a year. Analysts had been concerned about the banks having to repay the money they borrowed off the RBA in addition to the regulator’s requirements that banks issue 6.5 per cent of their total risk-weighted assets in the form of Tier 2 bonds. But if the RBA continues to tighten monetary policy, and risk-weighted asset growth continues to slump, this is quite unlikely. The bank treasury teams had been predicating their issuance needs off much higher balance-sheet growth assumptions, which means that they are almost certainly carrying excess funding.

First published in the AFR.

Investment Disclaimer Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments Pty Ltd (ACN 153 327 872). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting Neither Coolabah Capital Investments Pty Ltd, EQT Responsible Entity Services Ltd (ACN 101 103 011), Equity Trustees Ltd (ACN 004 031 298) nor their respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Institutional Investments Pty Ltd holds Australian Financial Services Licence No. 482238 and is an authorised representative #001277030 of EQT Responsible Entity Services Ltd that holds Australian Financial Services Licence No. 223271. Equity Trustees Ltd that holds Australian Financial Services Licence No. 240975. Forward-Looking Disclaimer This presentation contains some forward-looking information. These statements are not guarantees of future performance and undue reliance should not be placed on them. Such forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual performance and financial results in future periods to differ materially from any projections of future performance or result expressed or implied by such forward-looking statements. Although forward-looking statements contained in this presentation are based upon what Coolabah Capital Investments Pty Ltd believes are reasonable assumptions, there can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Coolabah Capital Investments Pty Ltd undertakes no obligation to update forward-looking statements if circumstances or management’s estimates or opinions should change except as required by applicable securities laws. The reader is cautioned not to place undue reliance on forward-looking statements.

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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