By Paul Ho (guest contributor)
The interest rate a bank charges you is the reward for taking a risk with their capital on you as a borrower. The interest rate is often referred to as the “cost of funds” or hurdle rate.
What are the key factors that affect mortgage interest rates? In this article, we will examine many of the factors that affect this critical rate, especially in view of the potential Federal Reserve tapering that could push up interest rates as early as later this year.
1. Risk to Capital
If the lender perceives a higher default risk on its capital lent out, it will demand a higher interest rate. This can come from shocks to the financial system from within the country or beyond. As the world’s financial systems are increasingly interlinked, any credit event far away can increase potential default risk.
2. Demand for funds
The increased demand for funds, when it outstrips the supply, will also cause interest rates to rise. The genuine demand of funds comes from the industry’s need for investment. The industry will borrow money for investments if they think their investment returns can better the interest rate. This type of capital demand can help a country increase its productive capacity.
The other types of demand for funds are for household consumption such as housing mortgages, car loans, renovation loans or personal consumption.
3. Supply of funds
The supply of funds varies in each country. The supply of funds can come in local currency or foreign currency. The supply of funds generally comes from banks. The banks in turn receive their funds from equity and depositor’s funds. These funds are then lent out to borrowers, lessing off capital reserves requirement such as BASEL III to maintain the stability of the banks via a capital adequacy ratio.
Financial institutions having excess capital may then lend these funds to other financial institutions on an overnight basis, 1 month, 3 months, 6 months and so on. This is referred to as the interbank rate or benchmark interest rate. In Singapore it is referred to as the Sibor rate; in London, it is referred to as the Libor rate; in the USA it is referred to as the Federal Funds Rate (overnight rate).
The supply of funds in a country depends on the money supply and the amount of depositor’s funds within a financial system. And in recent decades, the availability of credit (debt) also increases the supply of funds and is further complicating the issue of funds availability. The effect of credit (debt) on the supply of funds is not fully understood.
4. Government Intervention
A regulator or central bank usually intervenes in the overnight funds market. The effects of intervention then filter through to the rest of the tenures of the interbank lending rate.
5. Core Inflation and headline inflation
Core inflation measures inflation over a longer period of time for a constant basket of goods. Headline inflation measures the current inflation rate and can be impacted by short-term supply and demand imbalances, causing temporary spikes and troughs in pricing. Every country varies in the way they measure inflation.
When Core Inflation is on an uptrend, it can start to erode purchasing power and may lead to intervention via increasing interest rates.
Core inflation can rise when a nation is approaching full employment. Two main factors that contribute to the increase in disposable income are: 1. Higher total employment 2. Higher wages due to labour crunch.
More disposable income can push up prices of goods and materials. “Full employment” seems to be around 4% for the US economy. Interest rates may have to rise to cool down the economy.
Chart: USA & UK Unemployment Rate 1990 to 2015, (Source: Trading Economics)
6. GDP growth
When a country’s total gross domestic production grows too quickly, it can cause Core Inflation to rise. For example, if a country’s GDP grows by 5% and inflation grows by 6%, this means that the country has negative real growth. When an economy grows at a fast rate, it is usually accompanied by a higher inflation rate as industry clamours for limited supplies of raw materials and pushes production toward or beyond capacity.
If income does not keep pace with inflation, this can cause social unrest. A regulator may hence pull the brakes on the economy by increasing interest rates to cool the economy. Generally interest rates should somewhat track inflation, i.e. high inflation leads to high interest rates. However, interest rates can be kept at a certain level for an extended duration of time through intervention.
7. Cross-border Interest Rates
As the world’s major economies are increasingly interlinked, policies and regulations in other countries may affect another country. If interest rates are rising globally, then all connected economies will be affected. Funds may then move away to seek higher returns via higher interest rates (all factors being equal).
Chart: USA Overnight Fed funds rate Vs Sibor overnight rate (Source: iEconomics)
By observation of the chart of the US overnight fed funds rate versus the Sibor overnight rate, we can see that these two economies have correlated interest rates movements.
8. Funds Flows and Exchange Rates
The movement of capital across the globe has implications on each country’s economy. Some developing countries have a higher percentage of corporate and household debt denominated in foreign currency and, therefore, are at a greater risk from sudden funds withdrawal from their markets. Money supply in local currency may also suffer from withdrawals of deposits and repatriation of profits to foreign markets.
The exchange rate plays an important role for investors parking their funds in any country. If the investment currency is expected to weaken significantly against the investor’s base currency, investors may then decide to withdraw their funds from the invested currency.
Interest rates may have to rise when funds become scarce. Alternatively, some country’s regulator or banks may have mechanisms to react preemptively to raise interest rates to cushion against a weakened currency by increasing interest rates.
Many countries regulate the economy by varying the interest rates to regulate the speed of the economy. These monetary policy levers are effective for countries with a large domestic economy relative to trade, such as the USA where trade accounts for 13.5% of the GDP in 2013 (World Bank)
9. Shocks to the Financial System
Shocks to the financial system (systemic risks) may cause bankruptcies and defaults. There are many possible shocks to the financial system – just to name a few:
i. Exchange Rate Volatility via Quantitative Easing
Quantitative Easing (printing money) leads to currency devaluation. A currency which is devaluing may need to raise interest rates to slow down its devaluation as compensation to investors for holding the currency. Financial institutions and fund houses with un-hedged cross currency borrowings may end up bankrupt leading to a cascade of possible defaults. A case in point was the recent unexpected de-pegging of the Swiss franc to the Euro, which caught many by surprise).
Chart: Euros per 1 CHF 2010 to May 2015 (Source: XE)
ii. Sovereign Debt Defaults
Slow economic growth and high sovereign debt especially in European nations are risky. Budget deficits could cause potential defaults. Any possible risk of default or downgrade of the economy could cause interest rates to swing upwards further escalating risks. Sovereign bonds could become worthless causing a cascade of asset losses and bankruptcies for investors.
iii. Other Troubled Assets and Toxic Assets
Banks typically hold very little equity and are over-leveraged. Hence asset depreciation or write-downs (in the form of loss of asset value) could make the banks insolvent. Hence, the Basel Accord was formed to mandate minimum reserve liquidity in the world’s banking systems. The increase in the minimum capital adequacy ratio (CAR) means that the banks will have less capital to lend out and hence banks may demand higher interest rates.
The above are some of the key factors that affect interest rate movements. It is hard to decipher and predict the time frame of interest rate movements. Many credit events and unexpected shocks could happen which would severely impact interest rates.
Hence borrowers should not expect interest rates to remain at their current low rates forever, and should be cautious of over-leveraging themselves.
By Paul Ho, holder of an MBA from a reputable university and editor of www.iCompareLoan.com, Singapore’s first Cloud-based Home Loan reporting platform used by Property agents, financial advisors as well as Mortgage brokers.