Interest rates: fix or float?

Ron Bewley considers the direction of interest rates when it comes to investing, and asks: when are the best times to fix or float?

To fix or to float? This old chestnut crops up so often that I wish I had a dollar for every time I heard it. Rather than just argue the toss, let me put it into perspective with a discussion of where interest rates might be heading.

The bottom line is simple. Money markets determine interest rates — both fixed and floating — so at any time the two are in harmony.

That means that locking in a rate because you think you know where rates are heading is a waste of time — the future has already been priced into the fixed rate.

The only way to win is to know more than the combined wisdom of the Reserve Bank of Australia (RBA) and money market dealers.

It is always a good time to fix a loan rate if you don’t think you can afford higher payments if rates go up. This fixing is called risk management.

Current three-year fixed rates are pretty close to variable rates because no one is quite sure where they are heading. If you know for sure, please give me a call.

Let’s kick off with an historical perspective.

Home loan rates have climbed from 5.8 per cent (these are the ones without all the discounts and offers, as collected by the RBA) to about 8 per cent after the Melbourne Cup — depending on with whom you bank.

While this slug feels bad, have a thought for the guys paying 17 per cent in 1989. Current rates are below the long-run (post-war) average.

Of course what has happened is that lower rates have allowed people to bid up the price of an average house (and its mortgage) to where 8 per cent hurts nearly as much as 17 per cent did back then. A quick dose of 17 per cent now would cause the mother of all housing price crashes — but nobody is heading there.

Of course it would have been great to lock in a sharp rate before the heady days of the late eighties — but if rates had fallen as quickly as they did in the early nineties you would have been in tears until you could get out of your fixed-term contract.

I took some actual numbers from the Internet on 7 November from the same loan provider.

The variable rate was 6.64 per cent, the three-year fixed was 6.99 per cent and the five-year was 7.49 per cent.

That tells us the markets were factoring in an average 0.35 per cent per annum rise over the next three years and 0.85 per cent per annum over the next five.

In other words, we have had the bulk of our rate rises for the near future, but as the world recovers from the recession we didn’t have, rates will climb a bit more — or so the market players think.

And please note, these guys who deal in rates talk in terms of ‘yards’ — not the old imperial measure of ‘about a metre’, but slang for so many billion dollars in a trade.

To compare the three-year fixed rate with an equivalent variable rate, I calculated the implied three-year average variable rate over the same period of three years.

The RBA only published data from 1990 onward so we can’t see how we would have fared through the 1989 peak.

A mortgagee can choose between the fixed rate for three years in red and the implied variable rate in blue.

The higher line on that month loses for the next three years by the ‘gap’ rate per year.

‘Fixed raters’ would have been losing 2 per cent to 3 per cent per annum for much of the nineties — then they became the ‘grinners’.

Given that nobody predicted the global financial crisis (other than those who always predict one every year) would it have been worth the stress to keep choosing?

On average over 20 years the difference in rates was 0.1 per cent per annum.

If rates climb to where you are uncomfortable with the payments it is never really too late to fix.

It is better to have lost in hindsight in your repayments than to have lost your house by betting the wrong way.

There is little doubt in my mind that the world will be much better off in three to five years (at least in economic terms) so rates will be quite a bit higher then — but I can’t pretend to know in which months rates will rise. Remember in February, October and November this year nearly all economists got it wrong.

But it shouldn’t have mattered too much to mortgagees.

If rates are to rise and they go a month earlier or later than you or anyone else expected the impact on your annual budget is one month’s saving or loss.

On an average $300,000 loan that is $62.50 in a year. If money is that tight your mortgage is too big for you.

The game going on at the moment — and it is a game — is that all the central banks around the world would like low rates for themselves to get a bit of a gain from a lower exchange rate on their exports and economic growth.

The RBA has talked about this game and knows it can’t put rates up too much higher until someone else does — unless they want to crucify the tourism and education industries, amongst others.

But when the US eventually takes rates off their near zero base, it will give the RBA the chance to lift rates to contain inflation without sending the exchange rate though the roof.

So it looks like two or three more rate rises at most by the end of 2011 — but if the US keeps on growing the way it has over the last few months, and inflation kicks in courtesy of the second round of quantitative easing by central banks, watch out for some sparks in 2012.

Dr Ron Bewley is investment consultant to Infocus Money Management.