Impact of higher rates being under-estimated

Roger J Kerr sees a lot of interest rate risk being taken with mortgages, which may foreshadow subdued consumer spending over the next two years

24th Feb 14, 2:00pm by Roger J Kerr

By Roger J Kerr

Every man and his dog are expecting our short-term interest rates to increase by 2% over the next two years.

How quickly they might increase depends on the NZD/USD exchange rate which in turn determines the inflation rate the RBNZ are mandated to.

The question is whether borrowers are prepared for and thus hedged against these increases.

In the corporate borrowing world most companies run interest rate hedging policies that require them to be well over 60% fixed and fixed out to 10 years forward in various proportions.

However, there appears to be much less preparedness against the looming market risk in the home mortgage borrowing space.

Current RBNZ statistics reveal that 75% of home mortgage borrowers are either variable rate (floating) or are fixed for a period less than 12 months.

In corporate borrower interest rate risk management language “floating” rate risk is any interest rate re-set/re-pricing within 12 months.

History tells us that the majority home mortgage borrowers just go for the lowest rate on offer and 5.75% floating lending rates right now are less than the 6.29% two-year fixed rate offers. Clearly, the home mortgage borrowers are betting that average floating rates over the next two to three years will be less than 6.29% to 6.60%.

Alternatively, they know the mortgage rates will be increasing and are taking advantage of the current lower floating rates to build up cash reserves to pay for the higher interest costs later on.

However, as many will testify, such cash reserves tend to get spent on the latest toys that are available.

On the assumption that floating/variable mortgage lending rates continue at a 2.90% margin over wholesale market 90-day interest rates, by the end of 2015 floating mortgage rates could be as high as 7.75%.

Why then are there not more mortgage borrowers fixing two and three years today at 6.29% and 6.60%?

Must be that many are so highly leveraged against their house values/incomes they cannot afford 6.60% or they just do not believe that short-term rates will increase.

These borrowers must also believe that the rock star economy will keep the NZD/USD rate high and inflation low.

Seems to me a lot of risk is being taken here, which is one reason why consumer spending over the next two years may not be as buoyant as many currently predict.

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Roger J Kerr is a partner at PwC. 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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40 Comments

by Machiavelli | 24th Feb 14, 3:37pm 1393209435

I am amazed that more people didn't fix for 4 and 5 year terms last year when long term rates were low. If you fix for 2-3 years it looks like you will come off your term when rates are at their highest. What to do is a tough decision now.

by Grant A | 24th Feb 14, 7:30pm 1393223446

Machaveli - totally agree, an opportunity lost, but probably not too late. MB's comments are typical of much of the thinking/concerns, and who really knows for sure if fixed rates haven't already fully priced in the move. It was pretty much a no brainier 6-12 months ago but 30% of borrowers either took the MB attitude, or as Roger suggests, just couldn't afford a fixed rate only a small distance from the floating back then - we are right to feel afraid because in the end the central bank will do what it has to do. And like you, I am amazed at how people with a 25-30 yr mortgage think fixing for 1 or 2 yrs is achieving anything for the reasons you state.

My real concern is that the yield curve is actually understating where the floating rate actually goes, as it so often does at the start of a hiking cycle when people are complacent. If we don't get the global blow up in the next yr or two, and even if the US dollar globally does appreciate pushing the kiwi down, we could add another percentage or two into that OCR track. Point is it's a risk however big or small people think it is, but god help some if its the later problem, how would you forgive yourself because there's no one else to blame - they will though!

by MikeM | 24th Feb 14, 8:06pm 1393225583

I think a lot of people, including profressionals, believe capital flight is the sort of event that only occurs in emerging markets. While it hasn't been an issue for NZ in recent times, we were a victim of it in the 1980s when the US was racking up huge current account and government deficits. The resulting interest rate differential in the US caused major capital inflows to the US and of course NZ was forced to keep pace.

All that is required is a snowball event in much larger economy than ours and we are toast. No stopping it.

by MortgageBelt | 24th Feb 14, 4:07pm 1393211229

Not sure it's worth fixing. There's a big risk of deflation & global problems, which may lead to lower for longer.

Over the long term, floating is always cheaper for mortgages anyway. People are tired of reacting to the experts on fixing.

Also too many people got burned in 2008/2009 when breaking their fixed rates as rates plummeted.

We'll wait and see. Home-owners may be prepared to take a bit of risk & keep floating. As M pointed out: a 2 year fixed is hardly worth the effort - the 5 year rates are too expensive.

The Rate rises are probably over-hyped for NZ.

by MortgageBelt | 24th Feb 14, 8:32pm 1393227178

In Westpacs' commentary today:

"However, there have also been developments on the inflation

front that leave us comfortable with our forecast for 125 basis

points worth of hikes in 2014"

So lets put that on the record and check in December this year as to whether the OCR is 3.75%

(& if so, where the NZD is at)

by Grant A | 24th Feb 14, 8:50pm 1393228211

Whether it's nil basis points, 125 or 150, what will that prove MB ? What Westpac is saying is almost exactly what the market is saying and pricing into rates. The market is the whole world, not just banks, not just economists views,the whole world actually betting money on that view. You could be right, something happens and it's well less that that, but let's face it you could also be wrong, and if the RBNZ hikes by 25bps on the 13th you will have been wrong by 75bps on what you have adamantly stated many times in the past year - any fund mgr or trader would get the sack for being that wrong.

What would add a whole lot of creditability to your call (this new one) is for you to state clearly and specifically what the event, or events that will occur that will knee cap rates rises I.e be specific for the record so that if it goes the way you say we can look back and say "yes MB called it right for that reason" rather than something occurred that you did not predict to cause it which is of zero credit to your argument.

by MortgageBelt | 24th Feb 14, 9:11pm 1393229494

December 2014 OCR = 3.75

True or False?

We won't know until we get there.

But it's fun observing such fundamentalist predictions. And looking for the reasons behind the predictions, reactions to them, & the reasons why they may fail.

by Grant A | 24th Feb 14, 10:12pm 1393233171

Ok MB fair enough. I think it pays to be aware of what the market calls "tail risks". Something that could occur but a risk(s) that have been evaluated by the market against all other issues and risks and relegated to a tail risk I.e. Something that could happen but not considered the most likely outcome. It something that bloggers fixate on all the time but it doesn't make it the most likely scenario, just traps some other people into thinking so and acting/not acting.

People in markets who bet continually on tails risk do not stay in the market very long, success almost always relies upon appropriate risk management of the more likely scenarios, with an eye out to see if the tail risks develop further. Rates cuts last year wouldn't have even made it to the tail risk category, no hikes this year certainly would, something in the 50-125 range is just somewhere along the curve, and above 125 starts becoming a tail risk at the other end.

And remember that tail risk events are a two edge sword, some can spike rates. If this Deusche Bank prediction today of a 0.60c AUD came to bear how far do you think the RBA would have to put up their OCR (and RBNZ according as we'd be following most of their move lower) to protect the currency and stop a tradables inflation shock ? Check out the emerging nations interest rate reaction in recent months to the the currency inducted inflation that the QE taper shock to their currency has had.

http://www.smh.com.au/business/markets/currencies/fears-australian-doll…

I'd say the forecast is most definitely a tail risk, and the lesser likely of various scenarios currently, but tail risk can occur, on the upside or downside for rates and currencies. Risk protection over the next few years is THE only thing that matters.

by SK | 24th Feb 14, 9:29pm 1393230570

5.5% 5yr last year was decent, didnt anyone jump on that?
Wonder what MBs position is, seems v nervous about the whole rate thing.

by MortgageBelt | 24th Feb 14, 10:16pm 1393233370

Try this exercise: Datamine this site [& NBR, SMH etc] for every bank economist predicting rate rises since 2008. Every single year / month for 5 or 6 years they have been wrong. And have never been called to account for this.

Maybe [due to the law of averages] they get it right this year.

Perhaps the world has changed a bit since 2008, ie hard to get back to normal.

I just think most home-owners are comfortable to float or short-term, let the banks worry about their loans.

by Grant A | 24th Feb 14, 10:38pm 1393234703

MB - forget economists, contrary to what one idiot stated on here economists don't raise rates, they don't even have an influence on them, they just give opinions. Rather, look at the market, look at the yield curve, look at what it forecasts. Did the market get it wrong as well at times over the past 5 years, yes, go look at the yield curve in the first half of 2009. But what you've got to understand, the markets know everything of any substance that you know about factors impacting interest rates, plus more, and it bets it's money accordingly. There isn't one thing you know of any consequence that it doesn't and over time the market will be multiples more accurate than you (and me).

Let's leave it at that, as usual we won't agree by debating, things will just have to play out and see if it's the tail risks that come to bear or not.

by Simon | 24th Feb 14, 11:10pm 1393236618

Agree with Grant.

I'm fixed long. If the unlikely event occurs and interest rates spike very high I'm safe.

If unlikely event happens and ocr remains unchanged for next couple of years, then I've paid slightly more for the privilege of that safety.

If ocr tracks bank economists predictions then I'll be saving money.

by Machiavelli | 25th Feb 14, 9:40am 1393274443

This. If I was still floating I'd look to fix in the high 6's for as long a term as possible. If rates go up you won't have to suffer higher interest payments. If they go down you will be paying more than you could have been but isn't it worth it for peace of mind?

I appreciate we have seen 5 years of little or no rises. But this time QE is tapering and that's all the signalling I need.

by steven | 25th Feb 14, 10:24am 1393277063

An interesting point of view, lots of "ifs" If you have the Austrian? view of here comes inflation OK, well I certianly dont agree. Then again you have not clearly said why, or what will happen, or how long for.

Peace of mind, well over 5 years how much extra interest is paid that could have gone to paying down that capital? Thousands, which longer term makes you safer as you have less debt and become debt free sooner. I cleared 8+k of debt I odnt have interest to pay out on.

QE tapering means the support to keep this ponzi scheme going is being withdrawn, Ok fair enough. Yet the world's economy is at best treading water, with a huge deflation risk lurking there. take the EU, a very real risk of deflation, already high youth un-employment and a self-supporting sprial down once it starts.

For instance Im floating and I dont see the OCR rising much if at all and I think its more likely to go lower as a medium term trend. Now I do think there is the possibiity that we could get a short term spike as investors flee to the USA and will need a huge incentive to lend to us.

So there is some reasonable case to go for 6months fixed, maybe a year.

Of course in the probable event of deflation and recession, the if is, will our retail rates follow the OCR? That is a hard Q, if the wholesale rates stay "high" or go higher despite an OCR at say 1% because "investors" wont lend at a low rate then I cant see how our rates can drop and might well go up.

Once into deflation I think we'll see big asset losses, who overseas will lend at that risk? now thats an interesting Q.

Sure you can maybe protect yourself, but if a bank goes toes up Im not sure that the fixed rate you feel safe with will still apply....

Oh and if interest rates rise how many businesses will fold?

For me there are a lot of negative forces out there with dire impacts...

regards

by Machiavelli | 25th Feb 14, 12:04pm 1393283044

Many ifs steven. Many, many ifs.

Im floating and I dont see the OCR rising much if at all.. - steven

I'm fixed and I see rates going higher than expected in years ahead.

Bets are placed then. Now we just have to wait and see what comes.

I can afford to lose the difference between my fixed rates and floating / lower rates (if they go down). Can people who choose to float afford the additional payments if rates go up? That is the pressing consideration.

by Simon | 24th Feb 14, 11:56pm 1393239391

To explain why most mortgage holders are not fixed long term....

Like a fund manager i heard speaking on cnbc once said; humans are 'serial extrapolators'.

We see a pattern, extend it out into the future.

Ocr flat last 5 years = flat next 5. Last 5 years people have warned of rate hikes, every year they have been wrong = they will be wrong again this year. Or so our cognitive bias would lead us to believe.

by steven | 25th Feb 14, 10:34am 1393277670

Now you are trying to justify why you have fixed, because "others" dont know whats going on, but you do?

and you have based your life on what btw? Oh like an ever increasing growth world at an expotential rate based on finite energy supplies?

Aint gonna happen.

Expensive fossil fuel energy is crippling any prospects of growth. Hence why since 2006 with a high cost of energy the world's economy has slowed and stuttered and will continue to do so for years, until we exit the peak oil plateau, then we'll have a mega recession.

Now what will happen to retail rates in such a scenario is a very hard Q to answer, rates may indeed rise, but really thats unknown right now. The OCR however is in "danger" of going under 1%...

regards

by Simon | 25th Feb 14, 11:43am 1393281802

98% chance of OCR going higher this year by at least 50bps.

https://www.ipredict.co.nz/app.php?do=browse&cat=5

How about you put some money on OCR cuts to happen to year, and do a screenshot to show us. You stand to make 10x - 50x your money if your right. Good luck 'Mr Market'...

by steven | 25th Feb 14, 11:56am 1393282616

Interesting idea, but,

a) There is a difference on OCR cuts and retail cuts.

b) In the short term I expect there will be some OCR rises, in the medium term I dont think that will be sustained. So there is a case for a short term fix, 1 to 2 years, or a fix for say 6months to avoid a short term nasty blip, not sure if that would work.

c) From my point of view I exited markets almost 4 years ago, so I was 3years at least too early, ergo my timing isnt that hot I didnt allow for the human aspect, ie the Fed and other CB's doing "so well" at QE, so I wouldnt bet on 12months.

What I do look at is the fundimentals, so medium term sure....but really that could be 5 or 6 years off, depends on the triggering event.

I am "gambling" in effect, Im staying floating because I dont think we'll see much of a sustained OCR rise...

regards

by Alex13 | 25th Feb 14, 2:08pm 1393290525

This has been discussed in the past. For example,

by Grant A | 23 Jan 14, 9:19pm:

NZ forecast GDP around 3.5%

NZ terms of trade - 40 yr highs

Business confidence - 20 yr highs

Consumer confidence - 8 yr high

CPI 1.6% and rising (first positive CPI number in the Dec qtr in 6 yrs) - non-tradable inflation rising even stronger than expected. Govt annouces start of 9 anchor projects in Chch this yr.

Inflation expectations at 2.5% and rising.

Wages forecast to grow at 3.6% this year, more than twice the current rate of inflation

....with up to 18 month lags, for those responsible for implementing monetary policy you look forward not back as the market and informed commentators well know

by Alex13 | 25th Feb 14, 3:33pm 1393295636

You do not make much sense. What does "a greater economy" have to do with the necessity to raise the OCR?

Your vested interests that are compelling you to persistently talk down the interest rates also make you unable to comprehend relatively simple arguments. Inflation is the main target for the RB when considering the OCR decisions.

by steven | 25th Feb 14, 4:42pm 1393299728

Other economies have a lower OCR and their economies are in the doldrums with no significant inflation. So why is our economy that doesnt seem to be doing very well need a higher OCR than them and indeed raise it more?

Sweden raised its OCR as a result of the hawks and tanked its economy, hardly something worthy of repeating. 1.7% is anaemic frankly, way to close to a deflation risk still.

Sure if we were going through 2.5% and steaming at 3 or 4%. Sure if our un-employemnt really was dropping significantly....sure if factory utilisation was increasing.

regards

by Grant A | 25th Feb 14, 8:18pm 1393312723

Hi Alex, with respect, you're wasting a lot of time with that thread for obvious reasons.

by steven | 25th Feb 14, 4:34pm 1393299284

The last 2 dont really mean much, "confidence" can be misplaced / misguided you dont set an OCR just because some ppl feel better today.

You missed the negative indicators,

1) unemployment, dropping slightly, maybe, hardly going gang busters.

2) very low wage increases. Also consider the asymetrical aspect of looking at average wage increases. Sure some ppl are doing very well, many however are not.

3) Utility costs, council costs etc all rising, in effect the same effect as OCR rises, money is removed from wallets for nothing more.

4) An exchange rate that is too high for NZ businesses to compete well.

5) Overseas events are a risk.

6) 18months lag, is that still relevent (excessive) with so many ppl floating?

7) CPI and core inflation,

Inflation Rate 1.60 Dec-13 1.76 Mar-14 1.76 1.81 1.77 1.63 1.28 1.72 2.06 [+] Core Inflation Rate 1.54 Nov-13 0.25 Feb-14 1.54 1.7 1.7 1.62 1.26 1.71 1.97 [+]

Actual 1.6%, forecast was 1.76%, the next 4 1/4s 1.76~1.63% for 2014, for 2015 1.26% essentially flat....for 2 years....hardly inflation taking off. The last numbers are 2020 and 2030, I'll assume meaningless...

http://www.tradingeconomics.com/new-zealand/forecast

"According to its December Monetary Policy Statement, the Reserve Bank of New Zealand expects inflation to average 1.5% in 2014. In 2015, the Bank sees inflation averaging 1.9%."

Hardly something we need to take a huge swipe at.

You have some numbers showing differently? just whos data are you relying on? and their success rate?

NB Chch is a one off event....

regards

by steven | 25th Feb 14, 12:08pm 1393283309

A nice broad one is this,

https://www.ipredict.co.nz/app.php?do=browse&cat=5

Now if that was 2016, I think I'd place a bet. 7cents to collect $1? not sure how ipredict works.

regards

by Simon | 25th Feb 14, 12:22pm 1393284178

Yeah pays $1 for every option you buy if your right, and nothing if your wrong. I've never actually placed a 'bet' as I don't think I can predict the future better than the market

by steven | 25th Feb 14, 1:34pm 1393288461

A handful such as Steve Keen did, though their timing was also off.

So for me its who do you read.......

Are any of the same now saying recovery? interest rises? um no the reverse in fact.

Of course every Govn is going to do its utmost not to engineer a depression.

by steven | 25th Feb 14, 4:46pm 1393299985

So if I buy options at 7 cents and I get $1 per option, So if I read this right I put in $70 and get $1000 back?

that is quite an asymetrical play.

regards

by Simon | 26th Feb 14, 8:47am 1393357664

That is correct. (that option is for OCR cuts during 2014)

While you are at it you might consider placing a bet at the TAB on Zimbabwe to win next years cricket world cup. You will get similar returns. Both events equally unlikely to occur.

by Grant A | 25th Feb 14, 6:31am 1393263071

Very good description of it Simon. You can take it one step further in terms of behaviour; for those that do that, and it proves to be the wrong thing to have done with hindsight, they will sit there suffer the rise for some time, then panic, hook into much higher fixed rates close to the top when markets themselves have also over reached on the same sentiment, and they get screwed as rates fall. It's a cycle of human emotion lead by greed and then fear that been with us forever...it's always a case of "this time is different" in the public's mind as their memories are short as you suggest...and they extrapolate. With 75% floating or fixed less than one year, it's regrettably the same set up again. Too many think they know more than the market, and therefore what will really happen, when in fact none of us do.

by MikeM | 25th Feb 14, 7:17am 1393265866

Of course there is one good reason why some don't fix their rates for say a five year term is the lack of flexibility it brings. Five years can be a long time for many so if there is a desire to sell their home during that period,then obviously there's penalties for early repayment etc.

by steven | 25th Feb 14, 11:29am 1393280950

You also could pay a huge cost on that....

The RB seems to think a max of 4.75% OCR? hardly ground shakingly frightening. Assumingthere is no melt down as teh Fed tapers....or any other triggering event...

"If" of course we see deflation fixing at some high % would seem embarressing.

"desire" or forced sale? I assume if someone ends up in a mortgagee sale those break fees will be added to the bill...but being bankrupt is a 1 or 0 event the amount doesnt matter?

regards

by Grant A | 25th Feb 14, 12:56pm 1393286162

True Mike, thats a valid reason for many, but not so though for the likes of myself, who intends to remain here for a long time, and if I changed my mind on that the potential break costs would just be part of the equation to consider when buying/selling. Everyone has to look at their own situation, but I struggle to beleive that 74% of home owners who are floating/less than 12 months expect to sell their homes within the next year.

by steven | 25th Feb 14, 10:50am 1393278619

And it seems many of the rest who are "the market" in fact are just as ignorant....

Who in the market isnt "extrapolate"ing ever continuing growth? who in the market doesnt seem to think we can carry on paying such a high energy price and have growth?

I dont think that, but then Im out of the "markets" as far as I am able to.

What will really happen is we'll get less energy, now sure just what the actual rate of shirnking will be like isnt known...it could be an orderly 4% per year, or maybe 25% and somewhat riotious.

Meanwhile the markets will Im sure try and invent yet more financial instrumnets of mass destruction in order to give an illusion of some growth.

Just whos deluded?

An interesting Q.

regards

by Simon | 25th Feb 14, 11:50am 1393282207

Buffet's quote sums it up ' be greedy when others are fearful and fearful when others are greedy'.

I suspect people wanting to stay on low floating rates are being a little greedy....

by steven | 25th Feb 14, 12:00pm 1393282819

"greedy"? or needy? Im sure there are the needy out there with a degree of financial stress and a low rate is keeping them afloat.

Or like myself they have weighed up the likely future events and made a decision, based on the mess we are in I dont see much of an OCR increase.... withoutdire results and hence a drop.

regards

by Ricardo99 | 25th Feb 14, 9:02am 1393272136

The Banks and other 'experts' love talking up the rates. It's election year and whether rates should rise or not I suspect Keys is whispering in Wheeler's ear ' don't screw this up mate'. So I would be very surprised if rates rise for this reason alone, and even more so because the world hasn't really changed and NZ rates are laready high.

by steven | 25th Feb 14, 12:10pm 1393283446

I think Wheeler is his own man. So hang on for a 50 point rise, the Q is how long will rises last before they are retracted. 2015? 2016? interesting....

regards

by notaneconomist | 25th Feb 14, 10:17am 1393276650

How many people actually read the Financial Accounts of the RBNZ? 2013's have been out since about August of the same year and easy accessible on the internet.

How many journalists actually pull apart the information in the financial accounts?

by KH | 25th Feb 14, 3:58pm 1393297094

Lots of reasons not to fix for five years. Like selling the house. A lot of houses sell in five years. There is a dollar cost in that. Or deciding to change banks. Or deciding to pay it off. A chunk of borrowers will get divorced.