Why the fixed-rate mortgage cliff may end up more like a "rolling hill"

For those of us who are old enough to remember the turn of the millennium, one of the more peculiar remnants of that event was the Y2K bug.

This ‘bug’ was supposed to end civilisation as we know it. Computers and their inability to cope with the rolling of dates from 1999 to 2000 were set to malfunction, causing planes to fall out of the sky, nukes to be launched across the globe, and the internet – still in its infancy then – completely melt down.

The actual outcome was far less sinister than any of that. Nothing of any serious consequence eventuated, but a number of companies that sold Y2K bug software and updates made off like bandits.

Sometimes, things simply aren’t as bad as everyone is making out. In finance today, a parallel might be drawn between Y2K, the ubiquitous calls for a US-led recession, and the dreaded mortgage cliff that we’ve all been hearing so much about.

In the case of the last one, that mortgage cliff is supposed to derail the economy and send us all back to the dark ages, but not everyone is having it.

“So I think the fixed rate mortgage cliff is not as big of an issue as it seems. I think that, when you think about the Australian population, it's really a small proportion that's impacted by fixed rates. And so far from what we've seen, fixed rate borrowers, albeit given limited data, are actually performing better after coming off of the renewal than variable rate borrowers, or at least in line with them”.

That’s the view of Attilio J Qualtieri, Vice President/Bank Credit Analyst at State Street Global Advisors and a member of the Global Credit Research team for Fixed Income, Currency and Cash (FICC).

Qualtieri goes on to add that it was likely the smart money that got into the fixed rate market, capitalising on generationally low fixed rate payments.

“As a result, they were able to secure that and avoid a number of payments over the course of their mortgage, which has benefited them and supported savings. So, I just don't see the fixed rate cliff as being a cliff, I see it more as being more of a rolling hill, if you will”.

In the following wire, we discuss with Qualtieri how he is seeing investor sentiment, his outlook on the interest rate cycle and inflation battle, and whether or not we’ll see a banking crisis at some point.

The mood of the market

Qualtieri notes that whilst sentiment coming into 2023 was pretty challenged, and a recession was predicted by all and sundry, it hasn’t yet come to pass.

"Everybody was waiting for it, and then SVB happened, and you said, "Here it is," but then it never came".

He adds that sentiment seems to be coalescing around a soft landing narrative, noting that there are a handful of metrics that show sentiment has improved from start of the year, including State Street’s very own investor confidence index, which has been showing that institutions have added risk.

Aside from the data points, Qualtieri also points to the resiliency of consumers and “the money sloshing around the system from a liquidity standpoint” which have both delayed the cycle bottoming.

"I think overall sentiment has improved. I'd also note there's an equity piece of it and a credit piece of it. So, in speaking with traders in the equity markets, the theme right now is, when is bad news actually bad news? Instead of bad news being good news? Because that's what's going on right now".

As for credit markets, Qualtieri describes them as being “cautiously optimistic”, saying that there is some concern in future years about maturity walls - or the amount of debt that will mature in the coming years. 

“That could be something to contend with, but in the interim you have spreads that are tight…so I think it’s been pretty constructive," he said.

Peak or panic… where are we in the rate cycle?

On the question of peak rates, Qualtieri notes that the RBA and Fed both appear to be in “wait and see” mode.

“I think they have more of a tightening bias. Data momentum is starting to slow, but I don't see it likely that there are imminent cuts on the horizon necessarily. I think that there are long and variable lags that will take some time to play out," he said.

"They're starting to bite a little bit, and so I think that there's an impetus to wait and see a bit as that starts to come through”.

Whilst that might seem like fence sitting, Qualtieri notes that there are a lot of competing factors going into the mix, including wages, rents, and services inflation. He adds that there continues to be a push and pull from migration. While population growth helps loosen the labour market and contributes to economic growth, it also puts upward pressure on housing and rents.

The inflation battle: winning or losing?

When it comes to the battle with inflation, Qualtieri didn’t mince his words;

“I don't think the battle with inflation is over”.

That said, Qualtieri and the SSGA economics team think that the Fed appears to be winning the battle, “but is afraid to believe it and really doesn't want to admit it yet” for fear of a second and even larger mistake.

"We hit peak inflation, but I don't think that it is necessarily over. That's why I think that more of the tightening bias remains, and unless you see the impacts of policy really start to bite with some greater weight, a potential negative or downward pace in rates seems less likely here, especially near-term".

Qualtieri goes on to point out that the impact of rate hikes and the battle against inflation is creating uneven outcomes in the economy, particularly for those that are highly indebted and/or with low savings.

"There is pain being felt and you expect that to continue incrementally."

What shape are the banks in?

Whilst higher interest rates create fatter margins for banks, inflation and stretched consumers lead to fewer new loans and more bad and doubtful debts, and they are poison for lenders.

And we must not forget that earlier this year we saw three regional banks shutter, alongside European giant Credit Suisse.

When asked about the shape of US banks, Qualtieri says that the Fed was very prudent and proactive in their approach to the bank funding issues.

"On the liability side of the balance sheet, they were able to stem the tide of deposit outflows. And on the asset side, they were able to give the banks the ability to secure funding in a manner that did not result in the banks having to sell securities for losses."

In his mind, this has instilled confidence in the banking system, and he goes onto say that “confidence is the most important variable in banking. It takes the stairs up, but the elevator down, and it can dissipate really quickly”.

Qualtieri believes that because the Fed came to the plate and acted purposefully, the focus has shifted to the fundamentals. Specifically, the four "R"s: rates, recession, regulation, and ratings.

“The focus is really on the more challenging operating environment, as opposed to a bank run risk or the like. The focus is more on the operating environment and deposits are incrementally leaving the system, but that's always been expected with QE having ended and now unwinding, and so far it's proven to be very manageable”, says Qualtieri.

As for Australian banks, Qualtieri says that Australian banking system is “very, very healthy”.

"On an internationally comparable basis, capital ratios are best in class. They've improved in liquidity and funding since the GFC. And profitability has come down, but that's also because of higher levels of capital so you have less leverage”.

The key point with the Australian banks is that regulators have been on the front foot and actually deserve a lot of credit, because they've instilled stronger underwriting and have been arguably more proactive on interest rate risk in the banking book”. 

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