Borrowers have dodged multiple rate increases

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.