By now, you should have known that the era of ultra-easy money is drawing to an end for Singapore mortgage holders. Singapore’s domestic interest rates are rising at their fastest pace in a decade. How fast can this continue? how much can it grow?
The three-month Singapore interbank offered rate (Sibor) is commonly used to set the floating mortgage rate. It was expected by analysts the rate will be around 1% at the end of 2015, but it seems that the day will come sooner than later. By now, 3-month Sibor has already climbed to near 0.85%.
At this rate, with an average bank spread of 1%, most of the mortgagees are already starting to pay more than 2% mortgage rate, unless you have refinanced your loan like what I have advocated some time ago.
If you want to prepare for the higher mortgage interest rate to your housing loan, you must first understand the key factors affecting interest rates.
In general, Interest rate charged is the reward for the bank to take the risk on the capital. The interest rate is often referred to as the “cost of funds” or hurdle rate.
If the bank perceives a higher default risk on capital lent out, the higher the interest demanded. The causes of credit risks 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.
There are 5 main factors which will affect the mortgage interest rates.
#1 Demand vs Supply
Demand for funds
The increased demand for funds when it outstrips the supply will also cause interest rates to rise. Genuine demand of funds comes from the industry’s need for investment. The industry will borrow money for investments if they think their investments returns can better the interest rate. This type of capital demand can help a country increase its productive capacity.
The other types of demand are for household consumption such as housing mortgages, car loans, renovation loans or personal consumption.
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 the banks. The banks in turn receive their funds from equity and depositor’s funds. These funds are then lent out to borrowers, less off capital reserves requirement such as BASEL III to maintain the stability of the banks via a capital adequacy ratio.
The financial institution having excess capital may then lend these funds to other financial institution other 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).
#2 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.
If there has been a major project within a country, and this entity is borrowing a huge amount of funds within a short period of time. And assuming that the financial institution then borrows from the interbank market, that may cause overnight funds rate to spike for several days to distort the interest rates. In such cases, the bank’s treasury department may then file a notice/report to the regulator informing the regulator of such a transaction. The regulator may decide to intervene by pumping in funds to smooth out the volatility.
#3 Cross border Interest Rates
As the world’s major economies are increasingly interlinked, policies and regulations in other countries may affect another country. If for instance the global environment is rising in interest rates and going on a reduced risk appetite mode, then all connected economies will be affected competitively. Funds may then move away to seek higher returns via higher interest rates (all factors being equal).
By observation at the Chart of USA overnight fed funds rate versus Sibor overnight rate, we can somehow see that these two economies have a somewhat correlated interest rates movement. It is hard to assess whether it is a matter of competitive pricing, Funds flows or purely some form of pegging. If these two markets are highly correlated, then it would be interesting to know which is the leading indicator and which is a lagging indicator.
#4 Funds Flows and Exchange Rate
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 at greater risk from sudden funds arrival and withdrawal from their markets. Money supply in local currency may also suffer from withdrawals of deposits and repatriation of profits to foreign markets.
Exchange rate plays an important part for investor sparking 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 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)
Some countries such as Singapore manages its exchange rate to manage import inflation. Hence there may be less impetus for intervening in the interest rates, except as a preventive measure to stabilize exchange rate movements.
#5 Shocks to the Financial System
Shocks to the financial system (systemic risks) may cause bankruptcies and defaults. There are many possible shocks:
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 is the recent unexpected de-pegging of the Swiss franc to the Euro, which caught many by surprise)
As a result of this de-pegging of the Swiss francs to Euros, the Swiss Francs appreciated a lot versus the Euros. As a result, the Swiss National Bank set its interest rates to -0.75% to discourage people from holding Swiss Francs and to try to weaken the Swiss Franc.
Investors (with base currency in Euro) will bear with negative savings rates if they expect the Swiss Francs to strengthen more than the negative deposit interest rates.
Sovereign Debt Defaults
Slow economic growth and high sovereign debt especially in European nations are risky. Budget deficit causes 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.
The above are some of the 5 key factors that affect interest rate movements. It is inherently hard to decipher and predict the time frame of interest rate movement.
But one thing is for sure. Many more credit events and unexpected shocks await ahead and will severely impact interest rates, and affect your mortgage payment.
Click here to check the latest mortgage loan rates to see if you are paying a higher mortgage interest than necessary.