29 Mar 2022
Just because the RBA has not increased interest rates, it does not mean that they have not gone up!
Why did the RBA keep interest rates on hold while the Fed increased?
Consumer Price Index (CPI) inflation in the US is running at over 8% while reported Australian CPI inflation is around 4%. The Fed decided that it was time to act increasing the Fed Funds rate (equivalent of the Cash Rate) while the RBA seeing that inflation in Australia is half that of the US has held fire. The RBA knows that the markets described below will do some of their work for them. Although, if CPI continues to increase, the RBA will act.
Will the increase in US interest rates impact Australian mortgage rates? Yes, because Australian banks and non-bank lenders source about 50% of their funds from the wholesale global debt capital markets, i.e., from institutions in Australia and internationally, as their retail deposits, i.e., our savings accounts, are not large enough to support the demand for credit.
Why do US interest rate increases impact the whole world?
The simple answer is because the USD is the world reserve currency. A more detailed analysis reveals that forward exchange rates (AUD/USD) are determined by interest rate differentials, i.e., the 3 month forward AUD/USD rate is calculated from the current spot exchange rate (the rate you get when buying foreign currencies at a bank before you travel) and 3 month interest rates in Australia and the US. Any interest rate increase changes the AUD/USD forward exchange rate, which is passed onto Australian organisations and investors when they are transacting. As mentioned above there is also the global debt capital markets, and their activity impact Australian interest rates. The largest debt market in the world is the Euro dollar market.
What is the Euro Dollar System?
The Euro dollar system is comprised of all USD deposits and USD loans held outside of the US. It should not be confused with the USD/Euro foreign exchange rate. The size of the Euro dollar system is unknown as it is not regulated by any organisation although there are rules. The Fed cannot regulate it because it does not operate on the US mainland. It is a bottom-up system that started in the mid-1950s with the rebuilding of Europe under the Marshall Plan following the end of World War 2. It is called Euro dollar (system) because USDs were sent to Europe as part of the Marshall Plan were held in European banks. We are referring to it as a system because it plays an important role in supporting the USD as the world reserve currency status. A discussion on this for another time.
The Euro dollar and US treasury markets generally move in the same direction. Therefore, any increase in interest rates in the US will be reflected in the Euro dollar rate and passed onto to those companies raising debt, e.g., Australian companies and banks.
Russia/Ukraine and sanctions
The Russian/Ukraine war and associated sanctions will also have an impact on global interest rates because of supply line shortages as inflation may continue to rise. It has been reported that BMW and Volkswagen have both shut down automobile production lines because of their inability to obtain a simple cable wiring harness part that is supplied by production facilities in Ukraine. Airbus gets 50% of its titanium from Russia and Boeing gets 35% of its titanium from Russia. Russia and Ukraine together control 30% of the global output of titanium, so there will be delays in airplane production. Sixty-five percent of all the processed neon gas in the world comes from one company in Odessa, Ukraine. In a “tit for tat” Russia having been cut off from semiconductors, has cut off the western world’s access to neon gas used in its production. There are over 1,400 semiconductors in late model cars alone.
Net Interest Margin not Cash Rate
It is important to understand that banks when managing their assets (loans to customers) and liabilities (deposits from customers including debt capital market loans) manage Net Interest Margin (NIM). This is the difference between their average lending rate (mortgages – variable and fixed) and the average borrowing rate (deposits and institutional debt raised). They do not manage to the Cash Rate as the mass media continually says.
Increasing Mortgage Rates
Because of the above, banks and non-bank lenders will continue to raise mortgage rates. If you have high levels of non-tax-deductible debt now is a good time to focus on paying it down even though during periods of high inflation the real value of the debt falls.
If you have any questions about this newsletter or any other matter, please feel free to reach out.