How will the strengthening Aussie dollar affect mortgage interest rates?

The Australian dollar has been hovering tantalisingly close to the greenback for several weeks. On Friday 15 October it briefly hit parity with the US dollar before sliding backwards. What impact does this have for Australian home owners with regards to their mortgage interest rate?

Marking a historic first since it was floated in 1983 on 15 October the Australian dollar ($A) momentarily reached a peak of 1.0003 US dollars following the strongest suggestion to date by US Federal Reserve chairman Ben Bernanke that further quantitative easing (propelling more funds into its economy) is on the cards.

Most economists are forecasting the Australian dollar to continue its elevated state over the coming months, with leading economist further predicting that the US dollar ($US) is about to undergo a sharp decline off the back of expectations that the Federal Reserve will buy between $80 billion and $100 billion worth of assets per month under a new program aimed at bolstering the faltering US economy. The good news for mortgage owners is that this presents itself as further support that another increase in mortgage interest rates will weaken as the $A approaches US parity.

Herston Economics' chief economist Clifford Bennett, who has dubbed the Aussie dollar "the Stallion of the currency world" and is the only forecaster to have consistently targeted 96 cents all year, forecasts that the $A will continue its run above the $US to $1.03 early next year and US$1.08 to US$1.12 in 2012.

Talking to mortgage industry news site www.lendingcentral.com.au Bennett said: "The effect on the mortgage industry is extremely positive. Without a high Australian dollar the Reserve Bank would have been free to hike rates, perhaps significantly over the next twelve months. The appreciating currency is a deflationary force and will ensure the CPI stays in the RBA's target band. Therefore despite a strong economy, there is no reason/excuse to hike.

"A further raising of official rates would send the currency even higher than would otherwise be the case, and begin to damage our export earnings. So maintaining a stable interest rate environment is now the only course available to the RBA, which is great for the mortgage industry," he said.

"Wholesale funding costs will if anything be reduced by the higher currency. Overseas borrowings by the banks, which were not currency hedged, will now be easier to repay, and foreign investors will continue to be keen to buy bonds in Australia, benefiting from both a strong yield and an appreciating currency."

Asked whether he sees any justification in banks hiking mortgage interest rates independently of the RBA, Bennett laughs and admits: "It is not often the Treasurer and I agree, but there really is no justification for additional interest rate increases by the banks.

"The world's financial markets continue to calm down after the turbulence of recent years, and as they do, the cost of funding will continue to decline.

"Also their rates are a significant factor in how much market share they maintain, I think there is a real competitive price pressure against any individual bank independently raising mortgage rates."

The rising $A has had a dramatic effect on the Reserve Bank of Australia's (RBA) balance sheet, plunging it into the red and accounting for its biggest loss in its 50 year history. In the forward of the bank's annual report, released this week, Governor Glenn Stevens reported a $3.8 billion loss.

"The large rise in the exchange rate of the Australian dollar in 2009/10 had a major effect on the Reserve Bank's earnings. As has been explained in previous annual reports, the Reserve Bank, as the custodian of Australia's official foreign reserves, has a very large open foreign currency position. It cannot hedge that position," said Stevens.

"In years when the Australian dollar changes against the currencies of countries in which the reserves are held - the United States, Japan and the euro area - the value of those assets measured in Australian dollar terms changes.

"In 2008/09, as the Australian dollar fell, these valuation effects were strongly positive, and the Bank's earnings were consequently the highest in its history. As last year's annual report made clear, however, a large rise in the exchange rate would see the Bank record a loss. That is precisely what occurred in 2009/10, just as it had in 2006/07.

"The valuation loss arising mainly from the rise in the exchange rate amounted to $3.8 billion, which was the largest loss, in absolute terms, the Bank has ever experienced."

While this will have no direct impact on home loan interest rates Governor Glenn Stevens warns that paying dividends to the Federal Government over the next year is almost certainly off the RBA's agenda.