Interest Rates

Monday 07 September, 2009

The Reserve Bank review their cash rate next week and one can expect the Governor will again reiterate his determination to keep the rate at the current 2.5% until the “latter part of 2010”. But the chances are increasing by the week that just as the RB had to radically backtrack on forecast policy positions in the past five years they will again have to do so this cycle as well. Not that keeping the talk up from the RB is a bad thing.

The RB clearly want to make sure the economy has some reasonable momentum coming out of the recession which has now almost certainly ended and the best way they can do that is by improving business cash flow with low cost floating rate funding. In fact the need for the RB’s statements has been heightened by the rapid rise in the NZ dollar which is sapping the strength of the export sector while increasing the consumer incentive to buy foreign as opposed to NZ goods. There is virtually nothing the RB can do to influence the NZD so no point in trying.

Not that all exporters are feeling despondent. The NBNZ Business Outlook survey this week for instance showed a strong rise in the net percent of manufacturers anticipating higher exports to a net 21% in early August from 5% in July. This is the strongest reading since September last year. However most of NZ’s manufactured exports go to Australia – where growth is improving firmly – and the NZD/AUD exchange rate is just below average near 82 cents. Farmers are less well off as their exports are usually denominated primarily in USDs, then Japanese Yen, Euros, and the British pound.

Our expectation for the moment is that the RB will leave their cash rate at the current 2.5% through to July next year when they will start a series of increases taking it close to 6% come the end of 2011. The risk is the tightening cycle starts before then – just as expectations in Australia for instance have shifted radically in recent weeks.

A few weeks ago the common forecast was that the RBA would start raising its cash rate from 3% toward the middle of 2010. Then with strong data emerging the timing shifted to early 2010. Now our NAB economists expect the first tightening to come in November with the rate reaching 5.5% come the end of 2011.

This week 90-day bank bill yields stayed where they have been for four months now near 2.8%. Swap rates – which represent the base cost before risk premiums etc. to us banks of borrowing fixed rate money for lending at fixed rates – initially crept higher.

If I Were a Borrower What Would I Do?

I could either float at 5.85% and have that rate sit there for at most a year then end up probably near 9% at the end of 2011 or fix two years at 6.5%. The forecast average floating rate cost would be 6.6% over the two year period though if one used the offset facility in the Total Money package this would reduce to about 6.4% with about $5,000 in one’s current and short term savings accounts.

Therefore, if I were contemplating an exposure lasting only two years I could fix two years and take the rate certainty. If I were looking at a mortgage I won’t pay off for a decade then either floating or fixing two years would give the same new rate exposure come late-2011 so one could still initially think about fixing two years. But what about fixing three years at 7.45%? If we assume the floating rate reaches 9.5% at the end of 2012 then the average floating rate for the three year period turns out to be 7.5%. The current three year fixed rate is 7.45%.

Given the premium one should be prepared to pay for certainty then also one could fix.

What it comes down to then is this. We are forecasting that the official cash rate will rise from 2.5% now to 5.75% late in 2011, then maybe 6.25% come late-2012. These rises imply the floating mortgage rate rising from 5.85% to about 9% then 9.5%. If you think we are right then you toss a coin between floating and fixing.

If you think we are over-estimating the rise in interest rates then you float. Personally speaking, as a
generally risk averse person I would fix at least 18 months. But most people are currently floating and that is quite understandable because of another factor.

At the moment cash flow is king. Taking a 40 year low floating mortgage rate gives good cash flow in the current environment of general restraint. One can then choose whether to use that cash flow for other areas of spending or build up some precautionary savings, or optimally to get one’s mortgage principal down.

Therefore if your horison is three years or more there is nothing wrong with floating at 5.85% - especially if one intends having some spare cash on call along the way which can be used to offset the mortgage and effectively earn 5.85% tax free.

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