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Roger J Kerr says interest rate fixing decisions just got harder

Bonds
Roger J Kerr says interest rate fixing decisions just got harder

By Roger J Kerr

Interest rate risk in New Zealand is always twofold: Short-term interest rates out to three years determined by the RBNZ’s monetary policy settings and outlook, whereas the three to 10 year part of the yield curve is driven by US long term interest rate movements.

The simple explanation of why our three to 10 year swap interest rates are highly correlated to the US bond interest rate movements is that foreign investors into NZ Government Bond essentially treat our market as an enhanced yield extension of the US market i.e. they buy and sell NZ bonds alongside their buying and selling of US bonds.

Borrowers who have been reading our commentaries will have noticed the warnings we have been providing over the last 12 months that even though the RBNZ may keep the OCR static through 2017, future interest rate risk was still very real as both short-term and long term US interest rates were expected to increase.

The Trump pledges on corporate tax cuts, infrastructure investment and border taxes have been viewed by the markets as inflationary on top of the strong US economic data already lifting their inflation rate. Therefore the 0.80% increase in US 10 year Treasury Bond yields to 2.50% since November has pushed the NZ longer term interest rates higher.

As the chart below depicts, the upward slope of the NZ yield curve has steepened considerably over the last 12 months.

Whilst some borrowers may not see the risk with our OCR being static for some time ahead, the risk is that when short-term rates do start to increase next year the term rates will be higher than where they are today.

In other words, how much additional interest cost do you pay (over and above floating 90-day rates) for the next 12 to 18 months by fixing via a swap now? If the decision of the borrower is not to fix, then how high would 90-day rates have to go over coming years to be worse off in terms of annual interest cost.

No-one has the definitive answers to these questions and the impact of changes to interest cost on financial performance will determine the level of fixing (or as hedging policies dictate).

Daily swap rates

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Source: NZFMA
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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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12 Comments

Why fix , in the long run it makes practically little difference , and those who floated between 2006 and 2016 have likely been better off

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People can split their mortgage and place a bet each way. Have a portion of floating and have 1 year fixed. For a 1 year term what's the risk of paying more than the floating rate over such a short term?

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1 yr fixed is lower than floating, not higher

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Exactly my point. You need the floating rate to drop a lot for you to be paying more on a 1 year fixed.

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How so? All the banks are offering fixed terms lower than the current floating rate, and have been for quite some time now.

My current fix is 0.8% lower than what the same bank is offering for floating. The floating rate would have to pretty much halve tomorrow, and stay there for the remainder of the fixed term before I'd breakeven if I were floating.

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One of my fixed rates is 1.65% below the floating rate.

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Ah but for how long ?

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That one was for a 1 year term and it's just about up.

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1 and 2 year rates have consitently being below floating rates between 2006 to 2016 so you are wrong in your statement that those who floated between that period "have likely been better off". They haven't based on the floating v 2 year data from the RBNZ (see http://www.rbnz.govt.nz/statistics/key-graphs/key-graph-mortgage-rates). However, they would have been better off when compared to the higher longer term rates some signed up for.

Furthermore, the best rates for the last several years have been the one year rates which anecdotally (the RBNZ does not provide 1 year averages) have been 1.5 to 2% below the floating rate (based on my haggling). Even now the 1 year rates are the best on offer from most banks (see https://www.interest.co.nz/borrowing) been between 0.5 and 1% below floating.

While there is pressure on short term rates they by their very nature (being short term) are always a gamble. If you believe the US is heading for another pre-GFC take off then go long term. I myself think President Trump's first budget will be a disaster with massive funding cuts to pay for tax cuts and to keep the GOP happy... Imagine the criticism if President Trump ran a massive budget deficit... Somethings got to give.

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I will fix for 5 years in August and pay the mortgage off on the last day of the 5 years.

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@ the best status , if I understand you correctly , your idea is hoplessly tax inefficient , and fundamentally unsound

If you stay floating and make capital redemptions on your mortage the amount so paid off will return you whatever the mortgage rate is TAX FREE

In other words , if you pay $100k into your ( ANZ ) mortgage account your return is 5.75% or $5,750 per annum in reduced mortgage repayments

If you create a $100 k savings fund to pay it off you will get just 3%( if you are lucky) , pay tax of 1/3 rd an the rest will be eroded by inflation .You will only have $2,000 in income for the year , but your mortgage will still have cost you $5,750

If you buy NZX shares you will get a div yield of around 2% and some capital growth , but neither the dividend or the capital growth is guaranteed , so you could get zero

Its always been that the return from paying down your home-loan is the single most efficient investment you will ever make .

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It wouldn;t be my choice but if it works for you, go for it and don't listen to others

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