A good friend of mine, former interest rate trader and now Mortgage Adviser is probably the smartest bloke I know when it comes to financial translation - why; because he never purports to be an expert, but in the more than 20 years I have known him, he has been right most of the time about where interest rates are going as well as the direction of the AUD by simply, explaining the thinking behind his reasoning - the technicals are there but the focus (to me anyway) has always been on the fundamentals.
He sent me an email today on Australian Interest rates, I thought I should share it with you. How many of us know how the cash rate works anyway?
"Up, down or hold" seems to have become part of the Aussie culture. I am pretty sure that a betting agency already entices punters on the subject.
So much is said about this decision but few people know what the cash rate is, or how it works.
I decided to make it my mission to make sure that all of my clients know how the cash rate impacts on them.
Most people have worked out that the banks will generally move their variable home loan rates in line with the RBA cash rate decision. However, since early 2008, Australian Lenders have lifted their home loan rates about 1.20% above the cash rate movements. A big departure from normal behaviour.
Essentially the cash rate (currently 4.75%) is the price at which financial institutions like banks, credit unions and building societies can buy/borrow money from each other in a virtual shopping centre called the short term money market.
The shopping centre landlord is the RBA. The RBA manipulates the price of money within this market place by injecting or withdrawing funds. Good old supply and demand.
So when the RBA decides that the new cash rate is 4.75%, they don't actually "set" the rate but they control the flow of cash in the virtual shopping centre to make the price of money roughly 4.75%.
To put this 4.75% cash rate into perspective, most lenders are now charging us around 7.00% for a variable home loan.
Interestingly, in Australia around half of the money that has been lent out to us mortgage holders has been sourced from a different shopping centre that is very generally known as the wholesale market.
The price of this wholesale money had been quite high until recently. This is the main reason why Australian lenders have increased their rates beyond the cash rate for the last two years.
The very good news for 2011 is that the cost of this wholesale funding is getting cheaper as the wholesale markets thaw out and realise what a solid market Australian mortgages represent.
Lower funding costs (and big profits) are enabling new lenders to enter the market (primarily via mortgage brokers) to undercut the existing lenders. As a result you will start to see a mortgage price war as the banks try to maintain their massive market share gains over the last two years.
Good news for mortgage holders and also good news for the property market generally.
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