John Bolton argues interest rates will track below what the market is pricing in

John Bolton argues interest rates will track below what the market is pricing in

*The following article is by John Bolton, principal of Squirrel Mortgage Brokers. It first appeared here on Squirrel's website. It's used here with permission.

The next Reserve Bank Official Cash Rate (OCR) announcement is on 24th April 2014. We will almost certainly see another 0.25% increase in the OCR to 3.00% on that date.

Whilst mortgage rates will increase, that doesn’t mean fixing your mortgage long-term is the best strategy.

Tony Alexander from BNZ suggests he would fix for 3 years at 6.29%. Similarly we are fixing a lot of clients for a combination of 2 and 3 year fixed, but mostly so they relax and do more productive things than constantly ponder mortgage rates, which is a national pastime. The best advertised 3-year rate is 6.20% by SBS Bank who we deal with a fair bit. Above 7.00% the 4-year and 5-year rates are too expensive to warrant fixing, unless you need certainty. SBS has the best advertised 5 year rate at 6.85%.

Based on how we think mortgage rates will track anything between 1 year and 2 year fixed looks good. Fixing the mortgage postpones the impact of future OCR increases. And that’s the point, fixing doesn’t avoid higher rates; it simply offers a temporary reprieve. Most Kiwis will only fix for 2 years, which isn’t that long, so any benefit from fixing is short lived.

Future rate increases are already priced into the term structure of interest rates. The 2-year housing rate is higher than the 1-year housing rate because rates are expected to increase. Based on the current term structure, the break-even 1 year rate tracks as follows:-

'I expect rates to generally track below what the market is pricing in'

If you don’t need certainty then the real question is: Will rates increase faster, or slower, than what is already priced into mortgage rates? For what its worth I expect rates to generally track below what the market is pricing in, making short term rates more attractive. I think you’ll be able to secure a 1 year rate in a year’s time around 6.25%. To be better off fixing for 2 years than 2 consecutive 1 year terms the rate would have to be 6.75%.

Mortgage rates are driven by three factors: (1) bank margins (2) swap rates and (3) credit spreads (bank funding costs.) Swap rates are like fixed rates for banks and are also referred to as wholesale rates.

Part of the reason I’ve been adamant that mortgage rates wont go up nearly as much as most commentators suggest, is that in a rising rate environment banks will compete away their margins. If you want early evidence of that, the 2-year swap rate is currently 4.10% and banks are advertising 2-year fixed specials at 5.95%. That is a gross margin of 1.86%. As a comparative, back in late 2012 banks had 2-year fixed mortgage rates of 4.99% but the wholesale rate was 2.66% (gross margin of 2.33%.) Margins have already shrunk and we are only just getting started.

The Reserve Bank is forecasting a further 2.00% increase in the OCR to 4.75% by mid 2015. 4.75% is still a very low OCR by historical standards.

The last time we had an OCR near 4.75% was July 2003 during the Asian crisis. At that time the 2-year housing rate was the same as now at 5.95%. That was with an OCR 2.00% higher than today.

By July 2004 the OCR had increased 1.25% to 6.00% and the 2-year mortgage rate was 7.25%. So an OCR 3.25% higher than today, and also in a rising rate environment, had a 2-year mortgage rate only 1.25% above today’s rate. It is simply wrong to assume that a 2% increase in the OCR will translate into a 2% increase in fixed mortgage rates.

As interest rates increase the yield curve (term structure of interest rates) will flatten out. Fixed rates will not increase as much as the cash rate.

With an OCR forecast of 4.75% within 18 months, it will still be low (especially compared to its peak of 8.25% in 2007.) We are a long way off seeing a mortgage rate above 8.00%. What is important is the extent to which the Reserve Bank revises up its OCR forecast and to what extent it continues to increase above 4.75% in the latter part of 2015 and into 2016.

'The global economy is not fixed at all'

How will we fare beyond 2015? This is where my various blog posts about kicking the can down the road come back in picture. The global economy is not fixed at all, and I think rate increases and a high exchange rate will quickly kill off any growth in the NZ economy. That’s why we’re in for a long period of uncertainty and lower than normal interest rates.

Confidence is a reasonably short-term measure. My view is that we will see mortgage rates increase quickly for the next 12 months partially driven by the Reserve Bank and partly driven by consumer panic. In the short-term there is a lot of euphoria to pass through our economy. Ultimately rates will settle down, maybe even decrease a little. At the very least a 2 year fixed rate now, will get you through this volatile period.

Who knows what sort of craziness is instal for us in 2015-2016. Anyones guess, but you’d be a Lemming to think that the world economy is in a beautiful space.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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Very good article by John Bolton.  Mind you there is a brave assumption that banks really compete.
I think we need a little more discussion in New Zealand on the features of the modern day cartel.  Far more sophisticated than the smoke filled room of lore.
Apparently Mr Bolton has a blog. I like his approach, so I think I will look that up.

Wrong headline , the banks margins are so big across almost all lending types that they could never ' compete away " their entire marging income . 
They pay 2% -3% on fixed deposits , just under 3% to the RBNZ overnight to balance their books , and zero on cheque account balances .
Then they  lend at 15% on vehicles and machinery , up to 20% on personal loans and 15 to 20%  on credit cards .
Even mortgage loan margins are nearly 100% on their weighted average costs of capital
There is no buisness on the planet making these sorts of gross margins

Agree with this:
"The global economy is not fixed at all, and I think rate increases and a high exchange rate will quickly kill off any growth in the NZ economy. That’s why we’re in for a long period of uncertainty and lower than normal interest rates."

re bank margins, watch what they do.
i.e. we wouldn't be selling bank shares basis above.
 

compete? lol

The bogeyman of course is we do not know how joined at the hip the Australian banks are with the worldwide deriative market , will the FED continue to taper kicking the can down the road or will they print ? what lies in store is anyones guess , the FED (all central banks) are caught firmly in the headlights and anything can now happen . The finiancial war has started but how it finishes is anyones guess.  We have no control over where interest rates are headed and will have no options should they rise , it will be payback at some point in time and my guess is that the bankers will win.  

I'll add that ...generally...  as short term interest rates rise and the yield curve gets squeezed but before it becomes inverted....    banks start to lower the quality of their loans in order to offset the squeezed margins from borrowing short and lending long... ie. they'll lend to almost anyone...... maybe       (Banks are desperate for profit growth)
This is part of the "Real Estate Cycle" and the business cycle...  kind of.
What I'm saying is that we might be heading into a phase where it very very easy to borrow money...
 I agree with the article ...  I dont see mortgage rates in the 8% area.
just my view..

Banks in NZ operate like a cartel...no question of serious competition between them keeping rated down.

I have not noticed my term deposit rates moving at all.
Mortgages have been moving up since the Reserve Bank OCR announcement.
Nobody has mentioned this. Surely all that is happening is that the banks are increasing their margins between lending and borrowing.
Maybe someone knows why banks are getting away with this.