“During the economic slowdown periods, banks never perform well, simply because they are a very leveraged play on economic growth,” Liu says.

“My view is in the next 12 months banks will struggle, even though they will make more profit in the next three months – but that’s as good as it gets for the banks.”

Her comments illustrate the mixed forces facing bank investors in 2023. The banks’ underlying businesses are in strong shape, with low bad debt charges and rising margins – the result of banks lifting rates on loans faster than rates on deposits.

But markets are forward-looking, and the future is looking tougher due to a weaker economy that is likely to feel the sting of higher rates.

Lowe acknowledged this week that the full impact of rate rises on household budgets had not yet hit, because banks take months to lift repayments, and an unusually high number of people are on fixed-rate loans. However, no one doubts there will be some squeeze on household cashflow – indeed that is the whole point of rate rises.

The full impact of higher interest rates is one of the critical unknowns facing the economy, but investors have been running through a range of scenarios on the topic.

Reserve Bank analysis in October found that if interest rates hit 3.6 per cent (as markets expect), most borrowers would be “well placed”. Yet it also said 15 per cent of households would see their spare cashflows turn negative, meaning their incomes would not cover mortgage repayments and cost of living expenses.

Citi banking analyst Brendan Sproules this week explored the impact of rising rates on households, citing investor fears of an “imminent wave of mortgage defaults” from homeowners with variable-rate loans. Despite such worries, Sproules said that so far, variable-rate borrowers had experienced a smaller increase in their repayments than expected, partly because many customers had been paying off their loans ahead of schedule.

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Sproules said the weak spot was more likely to be among fixed-rate customers who locked in ultra-cheap loans when rates were at record lows, but who are facing “significant repayment shock” when their fixed-rate loans roll over to a higher rate.

This “fixed-rate cliff”, as it’s known, is already being closely watched by banks, and it’s expected the wave of fixed-rate expiring loans will peak in the second half of 2023.

Citing NAB data, Sproules said about 60 per cent of the bank’s fixed-rate customers were facing an increase in their repayments of more than 50 per cent, assuming a peak cash rate of 3.6 per cent. Sproules said he expected rising mortgage defaults from early in the 2023-24 financial year, and the most vulnerable customers were those with limited “buffers” who had borrowed a large multiple of their income.

While that is grim news for those borrowers, Sproules suggested the impact could be more “modest” than expected for bank shareholders, as the most vulnerable mortgage customers made up less than 1 per cent of banks’ mortgage books.

Credit Suisse analyst Jarrod Martin also painted a relatively sanguine picture for the banks’ mortgage books as the full impact of rate rises become apparent in the first half of 2023. In a note, Martin he said the bigger risk could come from business borrowers that are hit as stretched households pare back their spending.

“While losses in consumer segments are likely to be small, we are wary about small businesses exposed to monoline discretionary expenditure as we believe this will be where the stress is felt from a bank perspective,” Martin said.

Martin also said the benefits of wider margins would be “short-lived”, predicting that by the second half next year, the cost of deposit funding would rise, and banks would need to compete hard for loans in a slowing market.

For now, however, the full effects of rate rises are months away from being felt. Westpac chief executive Peter King last month flagged there would be mortgage stress, but he said it could take until the March and June quarters of next year to “get a good read on what’s happening”.

Until then, the market is likely to be on the lookout for any signs of chinks in the banks’ armor.

Principal at fund manager Alphinity Andrew Martin says the market is “skittish”, as it knows a downturn in economic growth is coming at some point, so investors are searching for any potential signs of weakness.

He said banks’ underlying businesses were still doing well, noting the latest earnings results showed no signs of rising bad debts, adding that banks were carrying solid bad debt provisions that were taken as a precaution during the pandemic. But as rising interest rates gradually put the brakes on economic activity, more investors will worry about loans going sour.

“The closer we get to some sort of downturn, the more people are going to talk about credit risk,” Martin says.

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