How high will interest rates go up?

By Ian Robinson

“How high will interest rates go up” is probably the most asked question after the discussion about the recent weather events and election has concluded.

The truth being said is that they have been going up well before the RBA made its move recently.

Banks lend money to farmers and commercial businesses in two key formats.  When you investigate your own funding structure you will note that your borrowings will constitute at least one of them, and sometimes both.

The first type of lending product is a “cash based” product.  This means it is not linked to the wholesale money market yield curve that gets splashed about in the newspapers daily.  Your interest rate in this instance will be linked to a bank’s internal “reference rate” with a client margin that is either added or subtracted from this rate.   This reference rate means absolutely nothing to the borrower, nor are the reference rates linked or related to the market rate.  It is merely a reference rate that the banks use as a dial to move their client’s rate up or down.

In the good old days, the movement reference rate was closely linked to the RBA movements.  But in recent years the banks have dislocated their love affair with the RBA and have willingly moved their rates more akin to protecting their margins depending on the trends relating to their cost of capital.

To understand what is happening to your own interest rate, you must keep a keen focus on what your “reference” rate is doing to understand what is then naturally transpiring with the interest rate you pay on your loan (assuming your client margin hasn’t changed).  A good reference point would be to look at your original loan agreement to see where the reference rate was when the loan was set, compared to where it is now.

The second type of lending product is the market linked product.  This means the interest rate you pay will always recalibrate to the market with every interest payment cycle.  If you pay monthly, then it will reset every month.  If you pay quarterly, then it will reset every quarter etc.

Given that the yield curve is a forward-looking barometer of future rates, and you are linked to this rate, then in a rising market your rate may be paying a slight premium due to this “normalised” phenomena of the yield curve.  In a sharply falling interest rate scenario (like that when COVID first hit), the yield curve can become inverse so you may be paying a discount on your rates.

Term premium – This is the cornerstone of our conversation.  In simple tones you potentially pay a contribution to the bank’s treasury for the term of the loan.  This is somewhat another function on how a bank recovers their cost of capital when raising capital in the market at that point in time.  It is also a risk adjusted return for term.  That is, five-year money will in theory be more expensive than three-year money since there is five years for the loan to go potentially south, hence higher risk, compared to a three-year loan.

What we are now seeing with all things being equal, three- or five-year money is now charging an additional premium to what clients paid for the same term a year ago.  So, when your old loan matures, and it is about to roll into a new loan – it will do so at a higher interest rate.  The difference could be 0.50% – 0.75%.  This is substantial increase on large borrowings.

When a loan is about to mature, this is a perfect time to really focus on re-presenting your business funding profile to the bank.  The ultimate result is to discuss a reduction on your client margin (interest rate) if your risk rating can be re calibrated to an improved position due to the outcome of your presentation.

Back to the original question outlined in the heading.  How high will interest rates go up? The answer lies within your own wheelhouse.  Executing a qualitative banking strategy, you can control to some degree how much rates go up compared to your peers and the market.


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