Fixed vs Variable Interest rates difference and their meanings

Discussion in 'Loans & Mortgage Brokers' started by paulF, 18th Jun, 2017.

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  1. paulF

    paulF Well-Known Member

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    Hey guys,
    i recall a while back i read something in regards to what the Banks think the RBA would do is easy to spot based on the variation between fixed and variable rates such as the below:

    Fixed > Variable => RBA will push Interest rates up
    Fixed~= Interest rates will be stable
    Fixed < Variable => RBA would cut rates

    Obviously, different banks would have different views.
    It does make sense for example for the banks to fix people on higher rates if they think the RBA would cut in order for them to earn more interest.

    What do you guys think of it all?

    Cheers
     
  2. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    Historically speaking, fixed rates have often been an indicator of where the next variable rate movement will be, but there's always been plenty of exceptions. This comes down to the cost of money on the various markets. If a bank can borrow money cheaply for a period of time, they'll probably offer this as a cheap variable rate. The reason they can borrow the money cheaply in the first place might be due to economic conditions that lead the RBA (which tends to be reactionary) to drop the variable rate. The opposite can also be true.

    These days the specifics of fixed and variable rates are only moderately influenced by the RBA or vise versa and it has little to do with predicting what future rate movements will be. The banks aren't gambling, they're treating money as a resource. Rates are determined by what the banks can purchase it for as well as their internal costs and what sort of business they want to attract.

    There hasn't been significant RBA movements in years. Despite this we've seen significant fluctuations in variable and fixed rates, owner occupied and investor rates, principal & interest or interest only repayments.

    A few months ago most RBA predictions were that upwards. After last quarters economic results there's many predictions of further rate cuts. Despite this interest only and investment rates have been trending upwards for some time and will likely continue to do so, predominantly driven by the regulatory environment as well as consumer and political sentiment.

    Personally I think rates will remain low in general, but investment and interest only rates will continue to rise. Frankly though I don't really think anyone can honestly make long term accurate predictions.
     
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  3. Ross Forrester

    Ross Forrester Well-Known Member

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    The longer you fix rates the higher the cost of the fix. The banks have more uncertainty of the future and they price that in.

    And if the banks expect rates to remain stable the pricing of fixed rates will still be higher than variable. The banks are taking on an element of rates rising (even if it small) and they have to price that uncertainty into their business model.

    You are basically on the right track though. Bank expectations of interest rate movements is a major factor into their pricing of fixed rates.
     
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  4. Simon Moore

    Simon Moore Residential & Commercial Mortgage Broker Business Member

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    There are markets called 'futures markets' where institutions can enter a contract now, to agree to borrow $XXm for X years at X.XX% in X months time. Through a relatively simple formula you can calculate what the 'market' believes future interest rates will be. The banks have a hedging team whose only job is to ensure the bank does not lose money and they will say ' for our three year fixed rate we need to charge a minimum of X.XX%'. The bank then can then make a decision on where they put fixed rates.

    The interest rates that a consumer pays will reflect the: futures interest rate, the cost of the bank to hedge and they banks profit/risk margin that they apply. In general, the futures interest rate is the largest portion of the interest rate you pay. A rule of thumb would say support your conclusion.
     
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  5. tobe

    tobe Well-Known Member

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    I disagree. The banks view on what variable rates may be have no bearing whatsoever on their fixed rates. The only thing that determines fixed rates is the price the banks pay for that money over that term.

    They paid 3% in New York, or Zurich, they sell it for 4% here. If their buyer here wants to end early, they charge penalties. The profit is booked on the purchase, regardless of the RBA, economists predictions, etc.

    End of story.
     
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  6. paulF

    paulF Well-Known Member

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    Thanks for the great replies guys.
    @tobe , not sure i'm following your point. Why would the banks only rely on the cost of offshore lending to set their fixed rates? I did a bit more digging and found a nice publication from the RBA. Below is a snippet from that paper linked below:

    "In setting lending rates, banks consider a number of factors. A key consideration is their cost of funding, which reflects the composition and price of the various liabilities (including deposits) issued by banks (Hack and Fabbro 2011). Banks also take into account risk premia, including the credit risk associated with loans, and the liquidity risk involved in funding long-term assets with short-term liabilities. Banks' growth strategies, competition and the desired return to equity holders also affect banks' lending rates."

    That is more inline with what the guys above described. Add to that, In regards to the cost of money from NY or Zurich, meaning offshore money, banks' total funds constitute of mostly domestic deposits and only at around 20% from offshore funds as per below graph from the same paper so doesn't make much sense for the banks to rely only on their offshore cost of money to set their rates

    [​IMG]

    Developments in Banks' Funding Costs and Lending Rates | Bulletin – March Quarter 2016 | RBA
     
  7. tobe

    tobe Well-Known Member

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    20% offshore funds. What percentage do you think are fixed rates on Aussie banks books?

    Why would banks risk determining their own rates if they can simply onlend and crystallise a profit? If they want to make more they just add more margin.

    This is just my theory, I don't work in money markets or banks. It just doesn't seem practical to employ people to gauge risk, buy and sell, hedge etc. especially when larger overseas banks have tied up all the talent and resources on much larger books.
     
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  8. Rolf Latham

    Rolf Latham Inciteful (sic) Staff Member Business Plus Member

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    Lenders buy bulk fixed rates from various sources........ in onshore oz land, its from your and my super funds, that want a guaranteed cash based income and capital security.

    Banks primarily onsell those funds, their margins are thus guaranteed.

    ta
    rolf
     
  9. dabbler

    dabbler Well-Known Member

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    I think if you know any of this with certainty means you really do have a crystal ball....

    Fixed rates =payment certainty. For end users.

    And now in particular I think most things are out the window as there is going to be more intervention for now.
     
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  10. Redwing

    Redwing Well-Known Member

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    Yet they quote offshore costs

    With the Fed sure to raise rates again in the US, and APRA smacking investors what's the strategy here?

    We have a number of Variable IO loans at present