This is the feature article in ANZ's monthly Property Focus report for June.
By Cameron Bagrie*
The environment over the last few years has been one of record low interest rates, both here and abroad. The decision by the US Federal Reserve to set out a conditional timetable for winding down its quantitative easing (QE) programme flags an end to this “golden era”. Wholesale interest rates are sharply higher, and all else equal, there will be pressure for retail rates to follow.
While we’ve seen an end to the era of incredibly low interest rates, it doesn’t naturally follow that rates will trend higher in a sustained fashion. In a post-financial crisis healing world, you don’t see such trends. Movements tend to be of the “drift” variety.
However, the worm has turned: the lows for interest rates have now been seen, though it doesn’t necessarily mean that borrowers should rush in to fix, boots and all.
A TWO-BIT PLAYER AT AN INTERNATIONAL ROULETTE TABLE
The last few years has been characterised by interest rates at multi-year (or decade) lows. Central banks have had their feet firmly on the accelerator for the past four years. Policy rates everywhere have been well below their comparable historical averages: that’s a consequence of cleaning up an economic mess.
In addition to record low policy interest rates, central bank printing presses have been working overtime. In their third bout of quantitative easing since the global financial crisis (termed QE3), the US Federal Reserve are currently purchasing US$85bn of assets per month (buying bonds and other financial instruments), to keep longer-term borrowing costs low.
Central banks in Japan and the UK are also conducting large-scale QE programmes, whereas the European Central Bank has been using various mechanisms to try to grease the wheels and provide liquidity to facilitate greater bank lending. The end result has been historically low interest rates across the board – and not just in those countries carrying out QE. In New Zealand, the Official Cash Rate (OCR) has remained at record lows since early 2011, with mortgage interest rates hovering around 50 year lows.
The correlation between the month-average NZ 5 year bond yields and their US equivalent for the past three years has been 0.82: others’ sugar-pill solution to their economic malaise has kept longer-dated borrowing rates in other countries low too.
In recent months the US Federal Reserve has been preparing the market for the eventual scaling back of the pace of quantitative easing.
The US economy is the bellwether for longer-term interest rates: we all dance to their economic tune. Signs of improvement in the US economy have become more prevalent: it’s not across the board, but more consistent.
While in June the Fed noted that the withdrawal of stimulus would be data dependent, based on their current view of the outlook it expects to start paring back the US$85bn in monthly asset purchases towards the end of the year, with net purchases to have ceased by the middle of 2014.
With the federal funds rate close to zero, the scaling back and eventually ending of QE3 is more akin to easing off the gas pedal than putting on the brakes. However, markets have been quick to respond: US 10-year government bond yields have risen from just 1.63 percent on 2 May to 2.61 percent on 25 June, and are currently just under 2.5 percent.
We’ve seen NZ 10-year government bond yields rise by roughly 1 percentage point (to approximately 4.15 percent) over this period. Domestic wholesale interest rates have risen sharply too, placing upward pressure on retail borrowing rates. Of course retail lending rates are influenced by other factors too, such as international funding costs for banks, which come on top of wholesale interest rates.
It pays to keep an eye on deposit rates as movements in this area often signify pressure for borrowing rates to shift too. However, wholesale interest rates are still a key component, and with this in mind it’s useful to eye what the US Fed is actually articulating and what this means for NZ borrowers.
What steps are the FOMC likely to take in normalising policy settings? Remember in the first instance that US interest rates sit near zero, so the process of normalisation will be a long drawn-out one.
The first step will be the winding down and eventual ceasing of QE purchases. After that the Fed will start lifting interest rates – or tightening monetary policy – in the usual manner, by increasing the fed funds rate. There is likely to be a significant interval between the two periods.
Even after QE has been wound down (say, by mid-2014), the Fed are likely to leave the fed funds rate on hold for a significant period, with the majority of FOMC members in June signalling a 2015 start date to begin lifting it.
Subsequent climbs in interest rates are likely to be gradual, as the Fed has long said that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens”.
Some time after the first increase in the fed funds rate, the third and final “step” is to normalise the Fed’s balance sheet (i.e. the total stock of bonds bought through QE). We say “step” as this is not necessarily a step that needs to be put into action. Rather, this process is a naturally occurring one – the Fed’s balance sheet will shrink on its own with the passage of time as bonds mature and mortgage bond are prepaid by borrowers.
The Fed could accelerate this process by selling down its bond holdings, but comments from Fed Governors to date suggest that this is unlikely, for fear of roiling markets. However, if the Fed were to sell bonds, this would happen after QE3 is wound down, and after the fed funds rate has been lifted.
At the current point in time, the FOMC is contemplating winding back the amount of stimulus it is providing through QE – step 1. In Fed Chairman Ben Bernanke’s words, at the moment that is seen as likely to begin “later this year”.
What was so important about these words is that for the first time they put a time frame around the “tapering” of QE that markets had earlier been contemplating.
Fed announcements generally have significant knock-on effects in other markets, including New Zealand. As the chart below shows, NZ and US long-term interest rates tend to move up and down together, thanks largely to open financial borders and a common set of investors. Some of the recent lift in US interest rates stems from the fear that the start of “tapering” marks the beginning of the tightening cycle, bringing back memories of 1994 when US 10yr bond yields rose by about 3 percentage points.
However, it has been the unwinding of the QE discount that has added insult to injury. The presence of QE saw yields fall to levels well below those justifiable or consistent with the economic outlook.
Looking ahead, although the Fed will move policy in a measured manner, for markets it’s not about the here and now, but rather the long-term outlook. And now that the Fed has signalled it is pressing the accelerator more gently, the market has jumped to the conclusion that it will soon have its foot on the brake.
We have been here before – but what differs this time around is that US data is in better shape, adding some justification to the Fed’s actions. Indeed, had the market collectively believed the Fed was making a policy mistake and withdrawing policy accommodation too soon (as turned out to be the case after QE1 and QE2), bond yields would likely have fallen. They may well still do that, but for now, the focus is on an improving US economy, and rising interest rates.
What matters for Fed policy is (a) how quickly the unemployment rate falls, with the Fed targeting a 6.5 percent unemployment rate before lifting the fed funds rate; and (b) how inflation evolves.
As the chart above shows, unemployment has been falling steadily, but this is partly the consequence of lower labour force participation as discouraged workers give up, rather than a strongly recovering labour market. If monthly employment growth continues at its recent trend rate, the unemployment rate is likely to approach 6.5 percent by late 2014 to early 2015.
At the moment, inflation (as measured using the core PCE deflator – the Fed’s preferred measure) is well below target, but it is likely to lift as the recovery broadens.
There are two broad channels by which the Fed’s changing stance will affect NZ. The first is via interest rates. Technically, the most recent spike higher in global interest rates can be characterised as a “portfolio shock” caused by the buying/selling decisions of an (admittedly extremely large) market participant – as opposed to reflecting a sudden change in the outlook for the US economy (eg a GDP surprise).
In this light, the spill-over into higher NZ interest rates must be regarded as a negative spill-over. Obviously the Fed’s decision was based on an expectation that US growth will improve. But the point is, the US economic outlook has not improved as much as the recent very sharp rise in US yields would suggest.
The second channel is via the exchange rate. The improving US economic outlook and “tapering” debate have also been associated with a significant fall in the NZD vs the USD. Ironically, this changing mix of monetary conditions is better aligned to the rebalancing requirements of our economy. A lower NZD, all else equal, will feed through into higher inflation and improved growth (export) prospects, with both leading to a higher OCR.
There are thus a number of balls in the air, and we need to keep an eye on how both the exchange rate and global interest rates unfold, for these will be crucial inputs into how the interest rate environment unfolds here in NZ.
There are other channels of which to be mindful. The US economy may be looking better, but what about others? Europe remains a mess. The emerging market economies have been huge beneficiaries of low interest rates in the US (pegged currencies mean they’ve effectively had the same interest rates as Uncle Sam).
Capital has flowed from the core into the periphery, including China (an often-quoted source of upside for the NZ economy). Now we’re seeing flows reverse, out of the periphery back into core markets. That’s raising question marks about the sustainability of activity in the periphery and emerging market economies’ growth trajectory: witness the recent performance across emerging market equities, and growing pricing spikes in short-term money markets that signal cash squeezes.
The message here is not one of impending disaster but one of interlinkages: we reside in a world that is increasingly “coupled”. This means the withdrawal of US policy stimulus will have implications that flow far beyond the US borders.
In short, then, we have entered a new phase. Global interest rates are now heading broadly higher, and we are confident we have now seen the lows in long-term interest rates, which we expect to drift upwards over coming years. However, we can also expect significant volatility as the data evolves, and it is drawing a long bow to suggest the steep increases seen over the past few months will continue.
Indeed, it is entirely possible that the recent lifts in longer-term interest rates following the tapering message will show the US economy’s recovery and thereby push out the tapering profile in and of itself! For New Zealand, this means getting used to longer-term rates gradually rising – as distinct from trending – and a steeper yield curve as the spread between short and long-term interest rates increases.
WHAT DOES IT MEAN FOR NEW ZEALAND BORROWERS?
Typically movements in floating mortgage interest rates tend to reflect domestic considerations, with movements in short-term interest rates largely based on market expectations of what the RBNZ will do to the OCR. Lenders will also charge a premium to reflect the perceived risk of lending to particular sectors or countries: the higher the perceived risk of lending, the higher the interest rate charged.
The gap between the OCR and the 5.74 percent floating mortgage interest rate charged by most banks is currently around 3¼ percent, which is wider than historical norms of around 2 percent. In part this reflects still-elevated bank funding costs for NZ banks, with the global financial crisis seeing a step shift up in funding costs.
This, and the regulatory changes to promote more longer-term or domestic funding for banks has also seen a lift in domestic deposit rates in relation to the OCR as banks attempt to acquire funding from other sources.
Longer-term mortgage interest rates are more sensitive to global factors than shorter-term rates are given the greater sensitivity of longer-term domestic wholesale interest rates to factors affecting global wholesale interest rates. Recent climbs in wholesale interest rates tend to bear this out.
Since early May, domestic 1-year wholesale interest rates have risen by about 20bps (currently 2.84 percent), as opposed to a 40bps rise for 2-year wholesale interest rates (3.23 percent) and a 70bps rise for 5-year wholesale interest rates (3.95 percent). This shift in NZ yields broadly reflects what has happened to US yields. Given recent movements in domestic wholesale interest rates we are likely to see more upward pressure for longer-term fixed mortgage interest rates over time.
While domestic wholesale interest rates have gone up, the impact on actual retail mortgage interest rates has been mild to date, with only small increases to longer-term fixed mortgage rates by some providers. Our estimates of the average mortgage rate applying to bank mortgage debt is around 5.55 percent, a post-2000 low.
Related to this is the fact that the demand for longer-term mortgages is reasonably low, with only around 6 percent of bank mortgage debt fixed for 2 years or more.
While the interest rate worm has turned and the lows for interest rates are now behind us, it doesn’t necessarily follow that borrowers should rush in to fix, boots and all. It’s heroic to believe that the pending unwind of US$85bn of asset purchases – or even the prospect of it – won’t create the odd flutter of economic nervousness.
The global economy still faces huge challenges and any exit of policy stimulus is heavily conditional. Locally, NZ borrowers have been price sensitive and have tended to gravitate towards the cheaper rates on offer. Witness, for example, the $12.4bn rise in bank mortgage debt for 6 to 12 month terms, where
published rates are the cheapest on offer.
Borrowers also like the additional flexibility of being on variable rates, with around half of bank mortgage debt still on floating. All up, around three quarters of the value of bank mortgage debt is either variable or fixed for one year or less, with this proportion rising to about 94 percent if we include rates up to, and including, 2 years.
When interest rates move up the RBNZ will get some economic punch: that’s a reason short-term interest rates shouldn’t have to move up too far. Moreover, the RBNZ is actively looking at bringing in greater prudential oversight mechanisms such as loan-to-value ratio restrictions. They’ll take the heat out of how high the OCR and interest rates need to head as well.
*This article was written by the ANZ economics team which includes chief economist Cameron Bagrie, head of global markets David Croy, senior economist Mark Smith, strategist Carrick Lucas, and economist Steve Edwards.