Should you fix rates now - probably not!

One thing you can rely on is that when everyone wants to do something, it's almost certainly the wrong thing to do. That's how some of the richest people in the world (like Warren Buffet) make their money - find a stampede and quietly go in the other direction. (After everyone has said 'sell telecommunications stocks' Warren Buffet is buying - see the latest edition of The Economist magazine.)

We've been getting a lot of requests to fix rates lately. Of course as we always admit, there are legitimate reasons to fix rates, namely that one cannot afford to risk rates rising beyond a certain level. 

Nevertheless if one were to try to beat the bank by fixing the rate, this would be no time to try. 

Consider the following points. 

Basic variable interest rates are still available at around 5.85% from Peach. On fancy professional package type products they are available at 5.97% with honeymoons up front.

Most lenders now have five year fixed rates at between 7.3 and 7.6%. This means that rates would have to rise by another 1.3% and stay there for five years for the five year fixer to win their bet. Why don't I think this will happen?

• Firstly because even though rates may rise by more than 1.3%, they will come back down again. So the average interest rate over the period in my view will be well under 7.3%.
  

• Secondly I doubt if budget and professional package rates will even go as high as 7.3% in the first place. Why? Because debt levels are much higher now than they have been when we've increased interest rates in the past. Lower interest rates have meant that people have been able to afford more debt. They've borrowed much more - fuelling house price rises. 

So when interest rates rise now, much smaller rises restrain household spending much more effectively than they once did. The Australian economy has been strong and it seems to be going into a strong phase of business reinvestment which is notoriously difficult for policy makers to forecast and to control. So if I was looking at the Australian economy on its own, I'd agree with the pundits that interest rates would rise a fair way from here. But in the longer term there are big doubts about the world economy. 

The Japanese economy, once a global economic powerhouse, has been comatose for a decade slipping back into recession whenever any signs of growth arrive. Serious commentators are now beginning to comment on what would have been unthinkable for decades - a major developed country defaulting on government debt. Japan's government's debt is more than one and a half times the size of its annual economic output! 

Market pundits have been tipping a strong recovery in America. But some of the less excitable economists who don't make their money out of the market have been sceptical. Economists like Paul Krugman, who sounded warning bells about Asia when everyone in the market was tipping it as a sure thing, have been sceptical about the American economy for some time.

Krugman has argued that the American economy looks threateningly like the Japanese economy when it first went into decline in the early 1990s, with an asset 'bubble' bursting and an economy which is suffering from past over-investment. (Past over-investment is a problem because, having invested in things - like buildings and computers - before there was a real need for them, businesses have to invest less than normal and that depresses their spending.)

So if Krugman's right, Australia's interest rates are unlikely to be going up very far. Interest rates only need to rise if demand in our economy is running out of control. It's been prudent to raise rates to contain rising asset prices and economic growth running ahead of 4% per annum. (In fact the last two rises only took back the two interest rate cuts our Reserve Bank was sensible enough to make after the economic shock of September 11.) 

But we only need to keep raising rates if demand keeps running away. It looks as though the housing boom is over and exports will falter if the US and Japan are sluggish or worse. That, coupled with the reaction to such an outcome in business investment, suggests to me that paying 7.3% on interest rates over the next five years could be a mug's game.

There may be a useful fixing strategy however for risk averse borrowers. Short fixed rates, particularly one year fixed rates, are relatively low. Some of the most competitive fixed rate lenders also have fixed rate products which are not subject to the usual rigidities of fixed rate packages. Thus one lender we know has a rate of 5.95% for one year with early repayments allowed and a redraw.

And there are some mortgages on the market now with 'giveaway' honeymoon first year fixed rates without the 'hangover' at the end of the honeymoon period. That is they either convert to discount variable rates at the end of the first year or they have no exit penalties, meaning you can move into a budget loan at the end of the honeymoon for a small switching fee. A year on 5.49% (insulated from interest rate rises for a year) reverting to half a percent below the standard variable rate is a good deal, especially if rates rise further in the short term as well they may.

And make sure in your search for these products that you cut yourself into some of the sales incentives lenders offer brokers - use a discount broker offering rebates on the commissions they receive from lenders!

Cheers


AKA Nicholas Gruen  

Please note: The observations made here are general and indicative.Nicholas Gruen is not a qualified investment adviser. Further his comments are general and do not take into account your specific circumstances. Nor are they warranted as free from error in any respect whatsoever. You should not rely on any aspect of them without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns either up-front or trailing commissions from investments they recommend. We would be happy to let you know of service providers who provide advice on this basis.

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