Interest Rates

Thursday 14 May, 2009

Wholesale interest rates have moved higher again this week as the markets increasingly buy into the improving global outlook scenario so start thinking about portfolio managers shifting away from interest rate investments towards stocks, and central banks raising interest rates probably from late-2010. These developments are of greater significance to our wholesale borrowing costs in New Zealand than out of date labour market data, vehicle registration numbers remaining as weak as ever and telling us nothing we didn’t already know, and the government’s fiscal accounts deteriorating – also zero surprise there.

With expectations of further relatively futile monetary policy easing by the Reserve bank 90-day bank bill yields have ended today near 2.85% from 2.9% last week. But the one year swap rate has increased to near 3% from 2.9%, the three year rate to 4.13% from 4%, and the five year rate to near 4.83% from 4.63%.

The lows for wholesale borrowing costs apart from very short rates below perhaps nine months have been seen in New Zealand and as we have seen over the past week, monetary policy here has now hit the same wall encountered by central banks overseas many months ago. That is, cuts in the official cash rate are no longer leading to reductions in retail interest rates. This is because we borrow our money not at the OCR level but in markets offshore where competition by banks for funding is intense and investors demand huge risk premiums for supplying funds to banks rather than purchasing government securities, cash or maybe oil futures.

This means that when the RB takes at most another 0.5% off the OCR in the next three months we will see little if any change in retail interest rates. Will the RB therefore try to stimulate things by printing money? That seems extremely unlikely because here in New Zealand the need to do radical things to offset economic weakness is nowhere near as strong as overseas. Our economy already has a massive stimulus running through it from the interest rate cuts which have occurred over the past year, very loose fiscal policy, the lower exchange rate, strongly rising net migration inflows, and now a recovering housing market taking away that sector’s negative wealth effect perhaps very soon.

While in coming months bank bill yields are likely to decline a tad further, swap rates are likely to edge higher at very unpredictable speed. A key thing to keep an eye on here is how quickly sentiment regarding the world economy improves. If it keeps getting better then we could see some surprisingly large rises in fixed borrowing costs later this year. That won’t make a huge difference to this year’s and next year’s housing market because all home buyers will do is take shorter and shorter fixed rates.

Why No Mortgage Rate Cuts?

Easy. For a long long time we have been pointing out that the relationship between things like the official cash rate, bank bill yields, swap rates and where we lend have been radically altered by the global credit crisis. We banks need to borrow about 40% of the money we lend you from offshore, and internationally people would rather put their money under the mattress than lend to a bank. So in order to get that money we have to pay a substantial risk premium to these investors. This premium used to be about 0.1%. Now it is around 2.5% or 3.0%. In addition, here in New Zealand we are having to pay term deposit rates well away from the 2.5% official cash rate in order to attract funds – especially in a market where traditional depositors are chasing yields at government guaranteed finance companies or buying corporate bonds.

This has strong implications for our cost of funds because it means that at the same time as the RB cuts the OCR we are finding our cost of funds rising as old loans mature and we have to replace the money offshore at the new risk premium.

There is also the issue of the relationship between the official cash rate here and floating mortgage rates and the same thing in Australia. Why are their floating home loan rates lower than ours even though our OCR is 0.50% lower than theirs? Again the answer is easy. There is the cost of funds element above which hits us more than Australian banks which have the backing of a larger economy with better government accounts and a higher credit rating, plus much lower current account deficit and therefore dependence upon ongoing funding from foreigners than we have.

Also however the Aussie banks have traditionally competed for new customers using floating rates. Here in NZ when the appearance of fixed rates in the early 1990s coincided with new entrants to the home lending market the competitive battle has been fought with fixed interest rates.

And looking at the offshore credit availability problem from another angle, it is not just a matter of price but of the volume of credit available to NZ banks. In this environment having to find less money offshore is a good thing, therefore the ability to undertake competitive housing market plays through rate discounting is constrained. Hence tighter lending criteria and the discussion we had in last week’s WO regarding credit for the farming sector in particular going forward probably not going to be near where it has been in the past.

Key Forecasts

• Monetary policy easing with the official cash rate at 2.0% come mid 2009.
• Medium to long term housing rates have seen their multi-year lows – stop-start rises now lie ahead. Speed unclear.

If I Were a Borrower What Would I Do?

There are probably still a few people thinking that the safe thing to do is keep floating. Our view has been that while that will give you a reasonable cost of funds for the next couple of years you will have zero rate certainty and the cost of funds may not be as low as you are thinking. Those feeling that way – along with those still thinking fixed housing rates will dip to new record low levels in the middle of the year – seem to be failing to understand a few things.

1. As the outlook for the world economy improves shifting portfolio funds will see rising share prices and upward pressure on long term interest rates as fixed interest securities are sold.
2. There are some large stimulatory factors running through the NZ economy therefore the Great Depression scenario here was never on the cards – hence the scope for long term borrowing costs to remain low is again limited.
3. The Reserve Bank has done a fairly poor job with monetary policy in recent years. They took three and a half years to get monetary policy tight enough to greatly affect the housing market and by doing so actively reduced New Zealand’s potential growth rate by hitting exporters with a sustained over-valued exchange rate. They expressed misplaced optimism about the world economy in December 2008, then in March took the same tack and implied little scope remained for further cash rate cuts. Now they have flip-flopped the other way and say the outlook is so dire they don’t plan raising the cash rate until late 2010. Now we think they are too pessimistic regarding potential rises in inflation risks further out and we think monetary policy will start tightening by the middle of next year.

The upshot is that when one takes notice in particular of NZ’s housing market data and the slowly improving data releases offshore the scope for further reductions in fixed lending rates is minimal. Plus the ability of us banks to pass OCR reductions onto lower floating mortgage rate is heavily compromised by lender caution offshore as discussed just above.

This means that if I were a borrower I would not be optimistic about floating rates falling much from current levels and would expect increases in fixed interest rates to be kicking in again probably before the middle of the year.

From a risk-reward perspective then if one is holding off on plans to fix because one expects lower fixed rates then one must have a different view on the green shoots appearing offshore than the markets are increasingly embracing. Good luck. (You could be right of course!)

If I were borrowing at the moment I would see little benefit in holding off longer than one more week – in case a bank did decide to make a competitive plunge into the housing market. I would probably fix three years at 6.75%. If my finances were so tight I could not so that then I would fix half at the one year rate of 5.49% and half at the two year rate of 6.25% knowing I will be exposed to the global recovery story potentially raising interest rates more than generally thought two years down the track from now.

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