The RBA cut the cash rate to 1.75% this week and further rate cuts are expected. This sent the team at Huffle back to the loan lab to tinker with our model. Adjustments are required in our modeling, not only in the yield curve but also the pricing of interest rate derivatives.
The daily feed of Aussie government bonds show the recent decline in borrowing costs but also a slight increase in steepness in yield curve. This is indicated by the 2-10 Spread, which currently sits around 72bps. On a very simplistic level, this indicates that our expected pricing for a fixed rate, hedging and capital aside, is likely to be 72bs higher than where the variable rate home loan market is.
Updating our models and with a Return on Equity hurdle at 20%, we have reduced our expected pricing down from 4.99% to 4.49%. The main gains are due to the current derivative pricing and volatility.
Why is this the case?
As rates compress towards zero, the embedded call option in fixed rate prepayables has a reduced upside value to the borrower. The result is that this has a reduced sale value that would naturally be added into the price of the mortgage. The overall impact is a bigger reduction in the expected fixed rate loan price compared to the observed rate cut and decline in the yield curve.