What Fixed Home Loan Rates Can Tell You About Where Interest Rates Might Be Heading
If you've ever seen a bank cut its fixed home loan rates while the Reserve Bank of Australia (RBA) hasn't moved the cash rate, Like ING Bank did this week, you might reasonably wonder what's going on. After all, aren't interest rates supposed to follow the RBA? The answer is yes... and no.
The RBA's cash rate is the most important short-term interest rate in Australia. Changes to it have a powerful influence on borrowing costs throughout the economy, particularly variable home loan rates.
But fixed mortgage rates can move before the RBA does. And understanding why can provide a useful clue about how financial markets think interest rates might evolve in the years ahead.
There Isn't Really One Interest Rate
Many people think of "interest rates" as a single number. In reality, there are different prices for borrowing money over different periods of time.
There's an overnight rate. There's a rate for a few months. There are rates for one year, three years, five years and even ten years.
The RBA cash rate sits at the very short end of that spectrum. It represents the cost of money overnight.
But a three-year fixed mortgage isn't priced solely from today's overnight interest rate. Three-year market rates already reflect, among other things, expectations about what interest rates may do during those three years. And that's where things become interesting.
Fixed Rates Look Forward. Variable Rates Look More At Today.
Suppose the cash rate is 4.35%.
Financial markets don't simply say:
"The cash rate is 4.35%, therefore a three-year loan should be based on 4.35%."
Instead, the price of longer-term money reflects a much bigger question:
"What do we think interest rates are going to look like over the next three years?"
If markets become more confident inflation is falling and interest rates may be lower in future, longer-term market rates can begin declining even while the RBA leaves the cash rate unchanged.
The reverse can happen too.
If inflation proves more persistent than expected, or markets think rates may remain higher for longer, longer-term rates can rise without the RBA making any announcement at all.
That's why fixed home loan rates can move while the cash rate stays exactly where it is.
So If Fixed Rates Fall, Are Variable Rates About To Follow?
Not necessarily. Variable mortgage rates are much more closely connected to the current cash rate and banks' short-term funding costs. Fixed mortgage rates are more heavily influenced by forward-looking market rates and longer-term funding costs. Put simply:
Variable rates tell you more about where interest rates are today.
Fixed rates tell you more about where financial markets think interest rates may be heading.
Fixed Rates Are Not A Prediction
A fixed mortgage rate isn't a forecast. It's a market price. That price incorporates expectations about future interest rates, but also uncertainty, risk, bank funding costs, competition between lenders and profit margins. Markets regularly change their minds. Sometimes expectations prove correct. Sometimes they don't.
So falling fixed rates don't mean an RBA rate cut is imminent. But they can tell us that something has changed in the market's view of the future. A bank doesn't necessarily need to wait for the RBA to act. The market may have already moved.
Think Of It Like A Weather Forecast
A useful way to think about it is:
The cash rate is today's weather.
Fixed rates are the market's forecast.
Today's weather tells you what's happening right now. A forecast tells you what people think may happen next. The forecast doesn't control tomorrow's weather. And forecasts are sometimes wrong.
But if you want some indication of what might be coming, you don't just look out the window.
You look at the forecast as well.
What Should Borrowers Take Away From All This?
The next time you see a bank cut or increase its fixed home loan rates, don't assume the RBA is about to do the same. But don't ignore it either. Behind those fixed rates is a vast financial market in which the price of money over different periods is constantly changing as expectations about inflation, economic conditions and future RBA decisions change.
Fixed rates aren't predictions. They're not guarantees. But they can provide borrowers with another useful signal about what financial markets currently expect. If variable rates tell us something about where we are today, fixed rates can tell us something about where the market thinks we may be heading tomorrow.
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