As I write this, we’ve had a temporary reprieve from US rate hikes, with the US Federal Reserve (the Fed) keeping rates at 5to 5.25%. This will bring some relief to those of you still paying mortgages, or other personal loans. But this also brings questions as to why, and how exactly, US interest rates impact Singapore; especially since more rate hikes are probable toward the end of the year. Here’s what you should know:
The link between US interest rates, and Singapore loan rates
In Singapore, a lot of loans are pegged to the Singapore Overnight Rate Average (SORA). This is the volume-weighted average rate of borrowing transactions, in the unsecured overnight interbank Singapore-dollar cash market. Which is a huge mouthful, so let’s just say it’s reference rate that banks used to price their loans.
SORA tends to move in tandem in with US interest rates – so when US interest rates go up, SORA goes up, and vice versa when it goes down. This in turn affects loan interest rates.
For example, loans such as home loans are often described as:
3M SORA + 1.25%, which means the interest rate is the prevailing three-month SORA rate, plus a spread (bank’s charges) of 1.25%.
So if the three-month rate is 3.5%, then the interest rate on such a loan is (3.5% + 1.25%) = 4.75%.
So when SORA rises, the rate goes up, and vice-versa. The “three-month” SORA rate means that the home loan is revised to meet the SORA rate every three months.
But home loan rates aren’t the only ones impacted by SORA. Many other loan types, such as some personal loans, may also see rates go up.
What’s different about the interest rate environment today?
If you took out loans following the Global Financial Crisis (GFC), you would have been blessed with extremely low interest rates. In fact, at one point in 2011, home loan rates were so low that some loan packages had a negative interest rate.
(No, the banks didn’t pay the borrowers, because the loan terms state a minimum loan amount you have to pay back. Of course loan terms are tilted in the banks’ favour).
The reason was the Fed deliberately keeping interest rates near zero, to stimulate the economy. (To be clear, this refers to the US economy. We just happened to be along for the ride.)
This led to a period where borrowing was cheap, companies used credit freely, and there were all sorts of “zero interest” promotions for credit cards, credit lines, etc.
Loans were so cheap, that private bank loans to buy condos or landed property were had lower rates than HDB loans for flats.
Now toward 2020, the interest rates had started to normalise. But something came along to ensure another burst of low interest rates, in the form of a spiky little virus called COVID-19. Because the pandemic threatened to crash the economy, the Fed reluctantly kept interest rates low for longer.
Why wouldn’t they just keep it low forever?
When you have prolonged periods of low interest rates – and rates have been at historical lows for 15 years now – inflation starts to rise.
All that easy credit and “free money” in the economy causes prices to rise. The US is a wee-bit panicked, since in June last year, their inflation rate hit a 40-year high of 9.1%.
The Fed has implemented 10 rate hikes so far, at a furious pace, to try and jam the breaks on potential runaway inflation. Doing this means aggressively hiking interest rates, and trading short-term pain for long-term stability.
Locally, this creates the following effects:
- A shift away from riskier assets
- Aggressive refinancing or loan repayment
- Slower business expansion
- Impact on stocks and bonds
1. A shift away from riskier assets
You may have noticed that some exotic assets, like crypto, start to fare worse as interest rates rise. That’s because high risks become less rewarding in these environments.
If you could get an absolute return of 7 to 9% on an asset, does it still make sense to take a risk on volatile alternatives like art, crypto, fine wine, or even junk bonds? Investors – especially Singaporeans – tend to be more risk-averse than risk-takers. So as interest rates climb on safe products like fixed deposits, endowments, etc., we tend to see more of them liquidate the high-risk portion of the portfolios, and reinvest in something more predictable.
2. Aggressive refinancing or loan repayment
As interest rates rise, more people will rush to make early loan repayments. This is most evident in the housing market, where loans can have very long periods of up to 25 or 30 years.
This was perhaps tolerable when rates were at 2% or under; it’s less so now as rates climb past the 4% mark (and possibly 5% by the end of the year). This could result in more home owners rushing repayment, even in the face of prepayment penalties.
(If you try and repay a home loan before the loan tenure, banks may charge a penalty of up to 1.5% of the undisbursed loan amount, depending on the terms and conditions).
Those who aren’t rushing to accelerate loan repayments will probably aim to refinance, switching to loan packages from cheaper banks. There are bound to be some administrative and processing fees that go along with this, but it could be well worth the future savings.
You should consult with a mortgage broker on this issue, if you have outstanding home loans.
As for credit cards and personal loans, it doesn’t need to be said that everyone will be rushing to pay these off asap.
3. Slower business expansion
With loans being more expensive, businesses will borrow less. This makes some entities, particularly SMEs, less willing to embark on ventures like opening new outlets, going cross-border, or launching new product lines and services.
This could weigh negatively on the equities market (see below).
For businesses that are highly leveraged, this can pose significant refinancing risks. Consider, for instances, REITs. Many REITs only pay the interest portion of property loans, and don’t pay down the principal (this does makes sense for their business model, but it’s outside the scope of the article to explain it here).
REITs are thus reliant on being able to refinance often, and into the cheapest loans to keep costs low. But cheaper options may be tougher to find going forward, thus eating into their profits.
From an everyday perspective, Singaporeans may also end up contending with slower wage increases, or difficulty in finding the right employment. The slower our businesses grow, the fewer staff they take on; and the less they can afford for payroll.
4. Impact on stocks and bonds
High borrowing costs and slower expansion are bad for business, and hence bad for shares in those businesses. All it takes is for the Fed to suggest rate hikes, to send stocks dipping all across the globe.
There is, as in point 1, also a tendency to ask why you’d invest in a volatile stock market, when a simple fixed deposit can seemingly match the returns.
This isn’t, of course, to say that great stocks can’t be found in a high-interest rate environment; but you do need to be more discerning.
As for bonds, the prices of your bonds are likely to decline. Newer, more recently issued bonds will have higher interest rates, thus requiring lower prices on previously issued bonds to make them attractive.
On the flip side, this also means you have access to fixed income products that now pay higher coupon rates than in the previous decade or two.
In any event, the higher interest rate environment may call for portfolio rebalancing, if you haven’t looked over your investments in a while. Now’s a good time to get hold of a financial expert, and start asking if you’re still on track if the next rate hike comes. You can reach out to us on Single Digit Millionaire for help with that.
