Short-term and long-term interest rates in the US have overtaken those in Australia for the first time in a number of years, with the Reserve Bank of Australia predicted to be on hold for another two years. This makes funding via US interest rates unappealing for investors in Australia, reducing bank margins, and potentially beginning an unwind in the Australian mortgage sector.
Here’s how this works:
- Loan growth in Australia swamps deposit growth, requiring additional funding needs for Australian banks
- The US Federal Reserve raises overnight rates
- Attracted by the yields, Australian fund managers move out of cash and deposits into overseas assets
- To fund their balance sheets, Australian banks are then forced to increase deposit rates to attract deposits or must turn to money markets where yields are spiking
- Bank bill swap rates rise for smaller banks (Macquarie, AMP, Bendigo)
- To stop the erosion of margins due to rising short-term borrowing costs, mortgage rates rise as a result
So, the result of the increase in funding costs for banks is an ‘out of cycle’ increase in mortgage rates, that will negatively impact variable rate mortgage borrowers.
Now, earlier this year the Australian banking regulator ARPA relaxed restrictions on lenders that limited growth in credit allocated to buy to let mortgages to 10%. ARPA chairman Wayne Byres defended the decision, saying “lending growth has moderated, standards have been lifted and oversight has improved.” Moreover, there is a cap on interest-only mortgages at 30% of total new mortgage lending.
Nevertheless, there are still a significant number of existing mortgages that will be negatively impacted by an increase in rates. And house prices are now going down in many Australian cities as lending to the buy-to-let segment has stalled. So, even with the RBA on hold for the next two years, the Australian housing market is going to feel the pain of rising rates elsewhere. That’s my takeaway here. And it tells you how policy rate normalization in the US has unintended consequences due to the interconnected nature of the global financial system.
Earlier today I noted that Australia as one of three markets including Sweden and Canada where household debt was a problem due to mortgage debt. And so, we should be watching developments in this market carefully. At a minimum, it suggests an underweight for Australian financials, with the potential for some negative outlier scenarios due to a mortgage debt overhang.
But notice in the scenario above that Australian banks are excessively reliant on capital markets to fill the funding holes in their balance sheet due to loan growth that has outstripped the growth in deposits. That makes these banks vulnerable to a change in market conditions. And, in worst case scenarios, as we saw with Northern Rock in the UK a decade ago, you could even see a full-scale stop in funding.