To Fix or Not to Fix - Again!
Or ... the difficult life of a 'contrarian'.

A ‘contrarian’ is someone who thinks that markets act like herds and that because of this you can make money going against the herd. When the herd is buying at prices that are too high, you sell. When its selling, you buy. Some – perhaps most – of the greatest investors have been contrarians – like Warren Buffett.

So contrarians are buying shares right now as the pundits wonder ‘how low can they go?’. And they’re not buying so much property as it has had a good run.

How would a contrarian decide whether to fix her home loan or go with a variable rate? In fact most fixers end up paying more than those on variable rates – quite a bit more. The ‘yield’ curve slopes up. That’s jargon for saying that the longer you fix your rate – that is the more risk is shifted onto the lender – the higher your interest rate.

So if you can bear the risk, in the long run you can make money. There are a range of other problems with fixing to do with inflexibility which we outlined in newsletter 3 (though there are now some fixed rate products with the flexibility of a variable rate. Just ask us as we’ll fill you in.)

But now I think that the tables are turning. It’s a pretty good time to fix – at least if you’re risk averse. In fact it could save our average client over $15,000. First we’ll review the historical evidence about just how rare it is to win the bet you make when you fix. Then I’ll say why it might be a good time to fix. Then in true contrarian fashion, I’ll outline just how much you might be missing out on if you do fix.

Fixed versus Variable: An Historical Perspective

The following diagram shows just how rare have been the times when fixers have won their ‘bet’ to fix. We compared the three year fixed rate to the average variable rate over the next three years. So the question we asked was between September 1990 and February 2000 “if people could predict the future, how frequent would be the occasions when they’d choose to fix rater than float?”

The graph shows the difference between the average variable rate and the average fixed rate Thus, when the line is below zero, variable rate borrowers did better. The further below zero it is, the better they did. Clearly, the last decade has been very favourable for variable rate borrowers.

Figure 1


In fact in 86% of the periods surveyed, variable rate borrowers got a better deal. This is illustrated in the diagram in Figure 2. Last time we did this experiment – see newsletter 3 – fixers did a little better. Variable rates ‘won’ 82% of the time!

Figure 2


As we’ve commented before, none of this means that one should avoid fixed rates. Its just important you realise that fixed rate lending is lending with insurance and most of the time you’ll pay a premium for that insurance.

There’s an economist called A.G.L. Shackle who coined the term ‘kaleidic’. He suggested that thinking about the future is like looking through a kaleidoscope – it just takes a few grains of sand to change their position and everything looks different.

Right now we have one respected pundit talking of a classic 1980s style boom/bust cycle. The plot goes like this. Our economy has been growing strongly for a long time, with weak business investment which has recently begun to pick up. When business investment kicks in it is difficult to restrain. So mild increases in interest rates are unlikely to do the job. And our politicians are weak kneed when it comes to cutting government expenditure or increasing taxes (we make them weak kneed because we tend to vote them out if they do the right thing!).

So rates could rise a lot – and some suggest housing rates could go above 9%. Against this scenario, locking in now at below 6% is a definite ‘no brainer’.

But what if we just move a couple of grains of sand in the kaleidoscope? It’s true we’ve not gone through the economic excesses that have driven the poor performance of Japan, Europe and the US. But if our exports falter into those markets, and imports rise, activity in the Australian economy falls – and could fall into the economic torpor we see elsewhere. No one is expecting that to happen here but it shouldn't be ruled out. If it did rates could fall by three or four percentage points! People who’d locked in would be kicking themselves!

From 6.5% to 1.25% in 2 Years: What if we follow the US…. ?

Consider what’s happened in the US over the past 3 years. We pose the question “what if Australia follows a similar interest rate path?” US rates fell from 6.5% in January 2001 to 1.25% in January 2003! Figure 3 shows the US interest rate between January 2000 and January 2003 and a hypothetical Australian interest rate between January 2003 and January 2006 – the assumption being that Australia cuts rates at similar intervals and of a similar scale to the US cuts.

Figure 3


Taking this hypothetical scenario, how much would a variable rate borrower pay in interest compared to a fixed rate borrower? A borrower taking out a mortgage in January 2003 could get a fixed, 3-year loan at an interest rate of 6.35%. A variable rate borrower could take out the same loan at 6.05%. (We could have got Peach Home Loans borrowers better rates than this, but these numbers reflect the statistics available to us.)

Now as rates fall, the fixed rate borrower continues to pay 6.35%. By the end of the period – January 2006 – the variable rate borrower is paying interest of only 2.55% while the fixed rate borrower pays 6.35%. The difference is a whopping 3.8% or $3,800 for every $100,000 in the loan.

So why fix?

The above scenario illustrates how fixed rate borrowers lose out when interest rates fall. However, the real value of a fixed rate loan is that it avoids nasty surprises. If rates rise considerably, variable rate borrowers will be wishing they had fixed. To illustrate this point we compare the optimistic and the pessimistic scenarios (of course what’s an optimistic and what’s a pessimistic scenario depends on whether you’ve fixed or not!).

Figure 4


In the diagram the red line represents the scenario just discussed – with variable rates falling, whilst the purple line shows rates going in the other direction as the Reserve bank tries to restrain a 1980s style boom. Rates rise from 4.75% to 9.25%. So that’s the bottom line. The future is more than usually unknowable right now. For the average loan we arrange – around $350,000 – the amount at stake could be around $17,000. And when the amounts are that large, a lot of people like to insure.
 

Cheers,


AKA Nicholas Gruen
June 2006

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.