Interest Rates

Monedy 22 June, 2009

We have been expressing a strong view here in recent months that medium to long term fixed borrowing costs will be rising well ahead of any tightening action by the Reserve Bank in response to a range of factors. We have expected upward pressure as a result of borrowers who had been sitting floating deciding to fix (this is what happened in spades late in March), improving economic data offshore leading investors to shift funds into growth and risky assets and away from fixed interest investments, and expectations of tighter monetary policies causing reduced willingness to accept record low long term investment rates.

All of these factors have been in action and over the past week they have strengthened with the result that NZ swap rates have jumped up yet again. The implications for bank lending rates have been obvious since our “FIX NOW” comment of March 19’s Weekly Overview.
This morning the Reserve Bank left their official cash rate unchanged at 2.5% and noted that things are not looking as bad as they were though they still see some downside risks and might cut the cash rate further. They also said they don’t intend raising it before late 2010. Our view is that further cuts are not likely and as to when they start the tightening cycle – well that depends on too many uncertain factors to say anything other than the second half of 2010 probably.

Because the markets had factored in a chance they would cut 0.25% today and because some market participants have had their hopes of a renewed fall in swap rates dashed we have seen those swap rates rise to their highest levels in a long time. The two year swap rate has climbed to 3.88% from 3.6% last week. This is only just below the 3.99% level of early April and it is likely we will be above that level soon.

The five year swap rate has risen to 5.35% from 5.12% last week and this is the highest rate since late-November last year. The seven year rate has risen to 5.76% from 5.57% last week which is the highest also since November.

Rates are likely to creep higher from these levels over coming months though at a slower pace than that seen since March, with the yield curve becoming even steeper. The yield on 90-day bank bills has ended near 2.78% from 2.71% last week and is likely to remain low through to mid-2010.

Note that it is not just NZ fixed interest rates which are rising. In the United States rates have risen quite substantially recently with the ten year government bond yield this week rising above 4% for the first time since October last year. Last week the rate was 3.55% and a month ago 3.2%. The big move this week came about following comments from Fed. officials interpreted as meaning the Fed. may be close to ending its quantitative easing – printing money. In fact the markets have started to price in the Fed. raising its cash rate to 0.5% come December from the current target range of 0% - 0.25%.

Key Forecasts

• No more monetary policy easing with the this cycle.
• 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?

Here is something important worth noting. It is not just in New Zealand that mortgage interest rates have been rising. The graph below shows two important things. The first is that over the period of time between August 2007 and December 2008 when the Federal Reserve in the United States cuts its funds rate from 5.25% to 0% the one year US fixed mortgage interest rate only declined from 5.7% to 5% with a more recent low near 4.8% in late-April. The 30 year rate over the same period went from 6.6% down to 5.3% with a recent decline to 4.8% in April.

The important point is that a hefty easing of monetary policy produced only minor mortgage rate declines because of the huge risk to banks of lending to the housing sector and because they raise cash not from the Fed. at the funds rate but in the private market. Contrast that with NZ where over the period of time our cash rate fell 5.25% (July 2008 – March 2009) floating mortgage rates fell about 4.5% and the three year fixed rate over 3%.

The second important point to note is that the US mortgage rates have risen sharply recently as the markets have started to price in monetary policy tightening before the end of the year as hopes for growth strengthen and the Fed.’s expected withdrawal of unusual stimulatory measures commences. The US one year mortgage rate has risen from 4.7% to 4.8% and the 30 year rate from 4.9% to 5.3%.
http://www.freddiemac.com/pmms/

So NZ is not weird in having mortgage rates rising.

If I were borrowing at the moment my personal preference would remain for the security of the three year rate at 6.99% even though this rate is now just 1.1% below its average over the past five years and not 2.1% below as it was back in March when we strongly advocated fixing as long as one could tolerate.

However, we Kiwis tend to go for what we consider cheapest at the moment rather than give good thought to where things are going in the future. That is why so many people made the avoidable mistake last year of fixing five years at 9.19% when we were suggesting one year fixing. In the June 19 2008 WO we wrote “Borrowers should already have cut back to fixing only short terms and home buyers in particular should be fixing just six months or one year. There may be strong competition in the two year fixed rate area but personally I’d go just one year max.”

People fixed long term at the top of the interest rates cycle for the same reasons that other people did so in the middle of 1998 – in order to save cash flow compared with floating. Back in 1998 people fixed five years at 9.3% to avoid floating at 11.25% even though we wrote not to touch fixed rates with a bargepole. This time people fixed five years last year at 9.49% to avoid floating at 10.95%.

One suspects many borrowers will now simply float or fix one year. This is nowhere near as bad a decision however as fixing long term last year. We see a reasonable though not over-whelming chance the short term rates will still remain relatively low until late next year while the longer term rates continue to creep higher.

There are plenty of people who will choose to fix just one year or float in order to get their repayments to qualify within bank debt servicing limits. Plus some may still have an apocalyptic view of the world and expect rates to fall back down again. We don’t.

Most people will therefore now choose to float or fix one year. I’d fix three years.

Note however that this section always deals with the home mortgage fixing choice. But for business and farming borrowers the situation is different. Whereas there is only about a 1% difference between floating or fixing three years for home owners these other borrowers face a gap of 2-3%. This means many are finding it optimal from a cash flow management point of view to simply float. Doing so is likely to yield a low cost of funds until late-2010. Then those floating interest rates will be rising and the risk is they rise firmly over 2011 in particular.

So we would suggest that if you have decided to fund your business floating then allow for that interest rate rising 3% by late-2011. Use the time between now and then either to get your principal down, or find cost savings elsewhere to handle that extra burden.

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