Timing the market

When it comes to homeowners' mortgage financing decisions, expect discussion about 'timing the market' to increase over the weeks ahead.

With rates at extraordinarily low levels there has been speculation that the bottom of the cycle in cash rate levels must be near. And some borrowers have already moving towards fixed rate loans in anticipation.

Accurately predicting interest rate movements in the short-term, let alone the medium-term, is extremely difficult, to put it mildly. Does economic theory provide any guidance? Theory suggests that, on average, variable interest rates should be lower than fixed interest rates.

The explanation is as follows: Banks lend long and borrow short. There is always a chance that interest rates could rise, and, once lent out at a fixed interest rate, financial institutions cannot lend out these funds at a higher interest rate. Indeed, any given increase in interest rates will have a larger adverse impact on the value of the banks' assets the longer is the maturity. Therefore, banks require compensation in the form of higher interest rates if they are to 'lock-up' their funds in the form of fixed rate loans. This is consistent with the more general principle that assets with a longer time to maturity usually carry a higher interest rate.