By Bernard Hickey
Could mortgage rates have finally bottomed out? That's the question many are asking, despite the Reserve Bank cutting the Official Cash Rate at least twice and possibly three times in 2016.
The answer is important for those thinking of whether to fix or float their mortgage. Normally, the prospect of further falls in the Official Cash Rate (OCR) makes floating more attractive than is usually the case because floating mortgage rates are usually cut in line with the OCR cuts. But this time the banks are taking a different approach to cuts in the Official Cash Rate.
The Reserve Bank has cut the OCR twice or by 50 basis points to 2.0% in 2016, but banks have only passed on about 30-35 basis points of those cuts. That's because they say their overseas funding costs are increasing, although there's debate about that, and they say they can't pass on all the cuts to term depositers.
Savers are not growing their term deposits quite as fast as they used to, which means the banks have to work a bit harder to ensure they get the funding they need to keep growing mortgage lending. See more here from David Chaston on term depositors benefiting a bit from the banks not passing on all the OCR cuts to them.
The Reserve Bank also forces the banks to have a certain percentage of their funding from long term overseas bond issues and from local term deposits so they don't get burnt again by a freeze on international 'hot' money markets like they did in 2008/09. That in turn forces them to go after term deposits with higher interest rates than they normally would.
There's a couple of other things upsetting the usual bank behaviour this time around. The Reserve Bank is reviewing capital requirements for banks and many think the Reserve Bank will require the banks to hold more capital against their riskier mortgages to rental property investors. That would mean the banks have to put some of their profits aside as capital, rather than pay it out as dividends to shareholders. In preparation for these higher capital requirements from Australian and New Zealand regulators, the banks believe they need to build up their profit margins to put aside that capital. One way to build up their profit margins is to not pass on all the falls in the OCR and in wholesale interest rates to mortgage borrowers and term depositers alike.
Bank net interest margins had been easing back a bit in recent years as they competed a little bit harder for new business and as borrowers moved from more profitable floating rate mortgages to less-profitable fixed rate mortgages. But that fall in margins looks to have stopped and the banks now want to build up their net interest margins and profit stocks again ahead of these new capital requirements.
The end result of all this is that, for example, two year wholesale 'swap' rates have fallen 67 basis points to 2.09% this year, while the two year average advertised mortgage rate has fallen just 22 basis points to 4.4%. To be fair to the banks, the specials the banks offer of around 4.3% for owner-occupiers with deposits of more than 20% are better, but they also haven't fallen nearly as much as wholesale rates have fallen in recent months.
That's also despite the Reserve Bank signalling on September 22 that it planned to cut the OCR at least one more time in 2016, and possibly once more in early 2017. See more in my OCR report on September 22.
So the equation is slightly different to the normal situation, but not different enough to change the relative attractiveness of fixed mortgages vs floating. The bank's discounts on fixed mortgages, particularly shorter-term ones, mean that fixed mortgages are still more attractive than floating rate deals, particularly now the banks are not passing on all the OCR cuts.
So how does this fit into the decision fix or float?
My view for several years has been that interest rates stay lower and for longer than most economists and the Reserve Bank have forecast. They may even fall more than some expect.
That makes me more likely to fix for a shorter terms than longer terms because it allows me to take advantage of refixing at a lower rate reasonably soon and be able to take advantage of the discounts for fixing. The banks subsidise fixed rates at the expense of higher floating rates, so even though floating would normally seem to make more sense if rates were to fall, the cheapest and most flexible option is a shorter fixed mortgage. The idea of a 10 year fixed mortgage scares me witless.
That rate of 5.89% for 10 years might have looked good earlier last year when lots of people thought interest rates had bottomed out and would bounce, but what if the long term average for mortgage rates is in the process of a structural fall to more like 4-5% instead of the 7.4% we've seen on average over the last decade?
Imagine the break fees on a 10 year mortgage. As it turns out, TSB have since cut their 10 year rate to 5.75% and it is well above the 4.3% low rates on offer for one year fixed rate mortgages.
Could they go lower?
The slide in fixed mortgage rates over the last 18 months has made it much more difficult to justify paying the 5.60% offered by most banks for floating rate mortgages. The question then is: how long to fix?
The answer to that question depends on your view on where inflation in New Zealand and globally is going, and what you think central banks will do about it.
The jury is in overseas. They are treating this very low inflation and deflation as a cyclical issue that needs to be addressed with even lower interest rates and money printing. The People's Bank of China has also eased monetary policy repeatedly this year, as has the Reserve Bank of Australia. The Reserve Bank of New Zealand was an outlier for all of last year and was forced reluctantly to cut this year because inflation remains well below its 1-3% target range.
Only the US Federal Reserve is talking about putting up rates, albeit from 0.5% percent, but it has talked about it now for years without actually doing it. Some think there will finally be another US rate hike in December, but there remains plenty of doubts about whether rates will actually rise much at all. There may be one more small hike and then a long pause.
The global trend over 15 years has been for interest rates to fall ever lower. It's not just about falling petrol prices. There is now a growing debate about whether the deflation is structural and linked to changing technology, the globalisation of services and ageing populations. For now, central banks think it's cyclical. The wisdom of crowds in financial markets, particularly bond markets and stock markets, suggest it might be structural.
Structural or cyclical?
If it is structural then interest rates could remain low and possibly fall even further. Remember that interest rates averaged around 3% for all of the 1800s during the first age of industrialisation as new machines lowered the cost of production.
Some argue the world is entering a second age of industrialisation that delivers a similar type of 'supply shock' that lowers prices of goods and services for decades to come. The age of the smartphone has clearly driven down prices for many services, including shopping, accounting, music, telecommunications and taxis. Could we see many other areas such as education, health and financial services similarly transformed in a deflationary way?
Calculating the gains
There is a way to work out which mortgage and which rate saves you the most money, relative to floating rates. Interest.co.nz has built a special fixed vs floating calculator. See the table below for the latest calculations on a NZ$500,000 mortgage.
Here's a table that shows the benefits of moving a NZ$500,000 mortgage of moving from a floating rate of 5.65% to the various fixed options, assuming different interest rate tracks. The gains are indicated as a positive and the losses are negative. The middle track for the OCR is in line with market expectations. See all mortgage rates here.
The latest estimates, given the drop in fixed rates in recent months, suggest fixing is cheaper than floating across the board. Fixing for one year would give you the biggest benefit and the most flexibility to fix again at a lower rate if, as bank economists forecast, interest rates are cut again over the next year.
|OCR rate by late 2017||One year fixed (4.3%)||Two year fixed (4.6%)|
|OCR at 1.5% (low)||+ NZ$6,477||+ NZ$7,458|
|OCR at 1.75% (middle)||+ NZ$9,272||+ NZ$10,283|
|OCR at 2.0% (high)||+ NZ$12,379||+ NZ$13,389|