June 2020 Newsletter
Why are fixed home loan rates currently so low and what is quantitative easing?
Over the last few days I received a lot of queries about the new 2.29% 3-year fixed home loan rates. People are wondering why they are so low.
Variable home rates are currently around 2.9% or in some cases 3%, so why is the 3-year rate so much lower?
The short answer is: It is happening because the Reserve Bank of Australia is artificially reducing the 3-year rate to 0.25%, locking in substantial profits for banks even at 2.29%. There is no catch. So in which circumstances could one lose fixing at such a rate?
Interest rates dropping like a stone in the next 18 months to well under 2.29%.
You have sufficient funds available in an offset account to cover loan interest and you like the flexibility of being able to add to and withdraw from your loan.
You make a substantial windfall during that time and would like to but are unable to pay off the fixed part of your home loan immediately.
You sell your home during that period, do not buy another and will have to pay a penalty to pay off the fixed loan early.
If you consider the first unlikely (I do) and if the second part doesn’t apply to you and you don’t expect the third or fourth part to happen, then it could make a lot of sense to accept this very good offer.
Why is the Reserve Bank of Australia (RBA) artificially reducing the 3-year rate to 0.25% and how do they do it?
What the RBA is doing here is known as ‘Quantitative Easing’, which is a form of printing money. The RBA is buying up as many 3-year government bonds as it needs to so that the interest rate on those bonds drops to 0.25%.
How do they do it? The RBA bids up the prices for those bonds until the yield drops to 0.25%. The RBA is completely open about doing this and the government and the media are not complaining.
How does this happen technically?
Assume the Australian government issues a 3-year bond that pays 1%. This means that if you buy a $100 bond, you get $1 each year and after 3-years you get your $100 back. That is altogether $103 and that is not changing. So what would need to happen for this exact bond, paying $1 a year for 3 years and repaying the $100 at the end of the 3 years, to be made to yield only 0.25% and not 3%?
The bond itself will not change, nor will the repayment schedule but what can change is the price of the bond. When you buy a $100 bond on the bond market, you very rarely pay $100 exactly but either more or less to take account of the interest rate of the bond (here 1%), the duration of the bond (3 years), the prevailing interest rates and the principal being paid back ($100).
If you buy this bond for $100, you will receive an interest rate of 1%.
What happens if you buy this bond for $102.25 instead, i.e. you pay more?
You still get your $103 back in total but this means you only made $0.75 over the 3 years. That translates to almost exactly an interest rate of 0.25% for our example bond.
Why does this happen? Wouldn’t there be plenty of bonds available at $100 rather than $102.25?
That is the beauty of having an unlimited cheque book like the RBA has. Because the RBA announced that it will buy all 3-year government bonds on the market, paying up to $102.25 each, the price immediately goes to that level and the RBA doesn’t need to do much buying at all – unless there are suddenly a lot of sellers of 3-year Australian government bonds (the equivalent of this is happening overseas at times and the central banks have to do a lot of buying, printing a lot of money in the process).
Since the RBA has the ability to buy up all the 3-year bonds that are out there (this could, for example, be a 10-year bond that was issued 7 years ago and therefore has 3 more years to run), the RBA can manipulate the market until the 3-year government bond rate drops to 0.25% for everyone. Banks pay slightly more than the government (at the moment about 0.29%) and therefore can lend money at 2.29% and expect to make substantial profits unless there are lots of home loan defaults (which is unlikely).
How can the RBA do this?
The RBA has the ability to print money from nothing. It can theoretically write an Australian dollar cheque of any size, without actually needing to own anything to base this cheque on. This form of buying bonds to manipulate the interest rate is called quantitative easing and is done all over the world at the moment. It started after the global financial crisis and intensified during every crisis since. The RBA didn’t need to engage in quantitative easing so far but has now started to do so.
What is the advantage of quantitative easing – forcing the 3-year interest rate down to 0.25%?
It gives certainty to the market. Homeowners are more likely to buy a bigger property or to engage in renovations when they know their exact repayments for the next 3 years than if there is uncertainty.
The same applies for many businesses – if they can borrow very cheaply with certainty for three years, then they can undertake more projects than they would otherwise do.
At least that is the idea and to a certain degree it seems to work – if you make money cheaper, people are more inclined to spend it.
What are the dangers?
They are numerous and large but so far many haven’t materialised so people are getting less concerned about them.
One danger is inflation – if you put more and more money into circulation, people will eventually notice and will ask for more money for their goods and services. In Germany in 1923, in Zimbabwe in 2007/2008 the result was hyperinflation. Prices could double in a day and the entire country was impoverished. At the moment there is very little inflation and the reserve banks of the world are saying that they will eventually sell all those bonds they purchased and will retire the money they will receive, doing away with the inflationary impact. However, that date keeps getting postponed as the share and bond markets tend to fall substantially whenever they sense this ending of quantitative easing.
At the moment, however, the opposite is happening. For example the European Central Bank (ECB) is not just buying German and other very safe government bonds but also bonds from far less solvent borrowers and could therefore lose a large amount of money on those borrowers defaulting. It is a sign of desperation and the idea is to somehow get a sluggish economy going again without going through the pain of having to deal with the reasons why that economy is so sluggish.
One other danger is happening right now and its consequences are very unpleasant indeed.
As reserve banks hold interest rates artificially low through quantitative easing, investing in shares, property and other assets looks comparatively more attractive. Getting 0.25% from government bonds is a stark contrast to getting 6% in dividends plus franking credits from the big four banks (notwithstanding a short-term reduction due to Covid-19) if you own their shares.
Hence the price of assets is being bid up which is one of the reasons why the share market is so high.
Rich people own more assets than poor people and therefore benefit disproportionally from this bidding up of asset prices. This makes the world a more and more unequal place which is one of the reasons why politics are getting more and more aggressive and polarised.
So, overall, it is great to be able to pay a really low rate for your 3-year fixed home loan but it is not so great for pensioners as they get less and less for their money.
Are there any alternatives to quantitative easing?
Yes, but they are not pleasant. One is reforming the economy so that it is becoming more competitive. That is hard with the losers complaining loudly and the winners either not noticing or celebrating quietly.
Another is for reserve banks to stop trying to limit the impact of successive crises on the economy. This will lead to much sharper ups and downs.
If the above two don’t look pleasant there is also one interesting historical fact about interest rates:
Interest rates for safe borrowers have been dropping since the 1300s, i.e. since medieval times and, if the trend is applied to today, then interest rates should be where they are right now: At or close to zero for safe borrowers.
Why does this happen? Only recently we had much higher interest rates. The reason for the temporary (in the context of 700 years) 50-year blip of high interest rates were twofold:
We had a strongly growing world population that was getting wealthier in a hurry if you consider China and many other countries. We also destroyed an enormous amount of infrastructure in the hundred years up to the 1950s. There was therefore a large demand for money to invest, leading to money becoming at times very expensive, i.e. interest rates were high.
Now, with either little or no growth and comparatively little demand for more infrastructure in the world, less capital is needed and hence interest rates are going down to their more ‘natural’ equilibrium – zero per cent.
We are all still getting used to this new reality and it means a lot of things are changing. Dealing with these changes is a big part of my job and very enjoyable to do.
As always feel free to contact me with any questions.
AFP LRS GradDipFinPlan MBiostats
Life Risk Specialist , GStat Graduate Statistician
SMSF Specialist Advisor
Accredited Aged Care Professional
Accredited Estate Planning Professional
Authorised Representative 308223