Interest Rates

Tuesday 20 January, 2009

The news just keeps getting better and better for borrowers with the still worsening outlook for the world economy along with appallingly weak economic data in New Zealand leading to enhanced expectations of additional cuts in central bank interest rates both overseas and here in New Zealand. Last week the Bank of England cut the cash rate 0.5% to just 1.5% and tonight the European Central Bank are likely to cut their cash rate from the current 2.5% down to probably 2.0%. The Federal Reserve already has its funds rate effectively at 0% and the Japanese overnight rate is at 0.1%. The Australian cash rate sits at 4.25% down from 7.25% at the start of September with a 0.75% cut likely to come in the first week of February.

The Reserve Bank of New Zealand next review their official cash rate on January 29 and we expect at least a 0.75% cut down to 4.25% with the cash rate expected to bottom out at 3.5% mid-year. It could go lower. Expectations of interest rate cuts have soared this week following the much weaker than expected Quarterly Survey of Business Opinion released on Tuesday and discussed above, plus fresh woe offshore.

The yield on 90 day bank bills has declined to just below 4.50% compared with 5.4% a month ago and 5.15% at the end of December. The two-year swap rate has declined to approximately 3.87% from 4.85% a month ago and 4.55% at the end of December.

Let's take some time to put these interest-rate levels into perspective. First the official cash rate. It is currently 5% and has never been lower than 4.5% since being introduced in March 1999. To get a better feel for how low short term interest rates are we must look at 90-day bank bills. At 4.50% the yield is the lowest since early 1999.

In fact the way things are going bill yields are virtually certain to fall below 4% and if so they will then be the lowest since our records started in 1976.

We only have swap rates data from 1995. The two year rate of 3.87% is the lowest on record. So too is the five year rate at 4.39%.

We are getting into uncharted territory but the chances seem strong that wholesale interest rates will fall further. We think it is reasonable to expect the official cash rate will bottom out at 3.5% and possibly lower, bank bill yields may trough close to 3.5%, and fixed borrowing costs may also trough perhaps 0.5% below current levels by mid-year.

Key Forecasts

• Monetary policy easing with the official cash rate at 3.5% come mid 2009.
• The two and five year fixed housing rates falling below 6.5% in mid-2009 or earlier.

If I Were a Borrower What Would I Do?

Our comments here have been relatively strong over the past few months. Given the extreme deterioration in the world's economic outlook since the middle of September the attractiveness of fixed interest rates for periods longer than six months has gone out the window. We have been recommending fixing six months in order to ride down falling wholesale interest rates looking to lock in at much lower levels for a long-term rate at some point this year. We have considered floating to be a relatively expensive option compared with fixing six months.

Where things stand now is that interest rates have fallen but further cuts in fixed housing rates are imminent with the Reserve Bank expected to cut its cash rate at least 0.75% in two weeks time and more beyond. In fact we have just cut all of our fixed interest rates for periods beyond six months to 6.99% across the board. Some people may find these interest-rate attractive compared with where they have been over the past few years.

But if I were borrowing at the moment I would still fix six months though I would have a high expectation of breaking the rate before it matures. If I couldn't be bothered going through that process then I would just float and look to lock in at a long-term fixed-rate sometime almost certainly before the middle of this year. Just to clarify what fixing long term means. A two-year fixed interest rate is not long-term and neither is three years. I would look to lock in either a five-year or seven-year fixed interest rate at some point within the next few months. Our view is that wholesale interest rates probably will bottom out before the middle of this year and one’s personal goal is to be able to recognise the low point in the interest-rate cycle when it occurs.

This is not to be as easy as it may sound given the huge uncertainty about what is happening with the world economy and potentially extremely high volatility in the economic data measures over the first six months of this year. This means that at some point this year, just as we have seen wholesale rates plummet over the period of a few days and weeks, so too will they soar.

So if I were a borrower at the moment I would fix six months or float and gloat.

Source: Tony Alexander, Chief Economist of the Bank of New Zealand.