By Bernard Hickey
Even a few months ago, most borrowers thought the next move in interest rates was likely to be up and therefore fixing for as long as possible made sense.
So the June 11 decision by the Reserve Bank to cut the Official Cash Rate by 25 basis points to 3.25% and signal another cut has certainly taken a few by surprise. Floating mortgage rates were cut by the same amount and shorter term fixed mortgage rates have fallen as much as 50 basis points over the last six weeks.
Also, over May the Reserve Bank and the Government launched a pincer movement to try to slow house price inflation in the Auckland market, which Finance Minister Bill English has described as a "feeding frenzy."
The Government will introduce a "bright line" test from October 1 that will assume that anyone selling an investment property within two years of buying it is doing so as a trader and therefore must pay income tax on any capital gains made over that period. The Reserve Bank has also announced it will restrict Auckland rental property investors to no more than a 70% loan to value (LVR) ratio from October 1.
Many borrowers who are buying property in Auckland or elsewhere will wonder how this changes their decisions about whether to buy and how long to fix, if they're not already floating.
The mid-May announcements appear not to have had much impact yet on property markets, particularly in Auckland where sales volumes in April and May rose to record levels and median house prices also marched on up to new records. Auckland house price inflation is running at an annual rate of 15-20%, whereas inflation elsewhere is closer to 5%, or none at all.
Real estate agents and valuers however report a pick up in activity in Waikato/Bay of Plenty as investors spill out of Auckland with plenty of equity and look to keep borrowing above 70% in those markets outside of Auckland.
The question for many will be whether the slowing economy, thanks to a slump in dairy prices and weak wage growth, starts to drag on house prices. Certainly that slowing economic outlook is helping the outlook for interest rates.
March quarter GDP figures published on June 18 caused economists to slash their forecasts for the Official Cash Rate. ANZ now expects three rate cuts in 2015 and Westpac expects as many as four rate cuts, given inflation remains weak and consumer spending has been weaker than some forecast.
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 have forecast. They may even fall more than some expect.
That makes me more likely to fix for a shorter than a longer term. The banks subsidise fixed rates at the expense of higher floating rates, so even though floating should make more sense if rates were to fall, the cheapest most flexible option is a shorter fixed mortgage. The idea of a 10 year fixed mortgage scares me witless.
That rate of 5.95% for 10 years might have looked good earlier in the year, 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 over the last decade? Imagine the break fees on a 10 year mortgage.
Could they go lower?
The slump in fixed mortgage rates has made it much more difficult to justify paying the 6.5% 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 in recent months, as has the Reserve Bank of Australia. The Reserve Bank of New Zealand was an outlier for all of the last year.
Only the US Federal Reserve is talking about putting up rates, albeit from almost zero percent, but it has talked about it now for years without actually doing it. Some think there will finally be a US rate hike in September and longer term bond yields have risen through May and June, but there remains plenty of doubts about whether rates will actually rise much at all. There may be a small hike and then a long pause
The global trend over the 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 smart phone 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 6.5% 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.
|OCR rate by mid 2016||One year fixed (5.0%)||Two year fixed (5.2%)|
|OCR at 4.0% (low)||+ NZ$7,706||+ NZ$9,417|
|OCR at 5.0% (middle)||+ NZ$10,628||+ NZ$12,339|
|OCR at 5.8% (high)||+ NZ$13,843||+ NZ$15,546|