Bernard Hickey looks at whether to fix or float and how long to fix after the Reserve Bank says it has stopped cutting interest rates

Bernard Hickey looks at whether to fix or float and how long to fix after the Reserve Bank says it has stopped cutting interest rates

By Bernard Hickey

Could anyone have imagined in June 2009 when the Reserve Bank cut the Official Cash Rate to 2.5% that it would still be at 2.5% six and a half years later?

Over that time there have been any number of interest rate hike 'scares' where mortgage brokers, bank economists and even the Reserve Bank have warned borrowers of sharp rises in floating rates that would make fixing for as long as possbile the most attractive thing to do.

As recently as Waitangi weekend this year, TSB Bank launched a 10 year fixed rate of 5.89%, which made it to the top of the news bulletins. At that time the Reserve Bank itself was forecasting a rise of almost 2% in interest rates by the end of 2017. This time last Summer, fixing for 10 years or even five years at anything under 6% seemed to make sense, but only if you thought interest rates would inevitably rise.

But just as for every scare over the last six years, those hargingers of significantly higher rates have been wrong.

Now we are going into the summer with most fixed mortgage rates closer to 4% and with the Reserve Bank forecasting the Official Cash Rate unchanged at 2.5% until the end of 2018.

Two of the big four bank economists (ASB and Westpac) are forecasting the Reserve Bank will have to cut twice more to 2% by the middle of next year. If that happened, most fixed mortgage rates would easily drop below 4%. One bank, SBS Bank, is already offering a one year special rate of 3.99%.

The question for borrowers now is will interest stay as flat and for as long as the Reserve Bank says. Or will they fall further?

The Reserve Bank has been repeatedly wrong by over-estimating inflation over the last three years. It could be right from now on, but only if the global economy grows much faster than most expect and inflationary pressures surge through the economy in a way they haven't for at least the last five years. That would require, for example, a much higher oil price and a much lower New Zealand dollar.

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 than a longer term because it allows me to take advantage of refixing at a lower rate reasonably soon and being 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 seem to 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 5.89% 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 on average over the last decade?

Imagine the break fees on a 10 year mortgage. As it turns out, TSB have already 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 slump in fixed mortgage rates has made it much more difficult to justify paying the 5.75% 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 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 December, 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. Long term bond yields have actually fallen in the last month on worries about China exporting deflation and another slump in oil prices.

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 5.75% 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 two of the big four bank economists forecast, interest rates are cut again next year.

OCR rate by late 2016 One year fixed (4.3%) Two year fixed (4.5%)
OCR at 2.5% (low) + NZ$7,133 + NZ$8,792
OCR at 3.5% (middle) + NZ$9,970 + NZ$11,629
OCR at 4.5% (high) + NZ$13,088 + NZ$14,747

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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Bernard, i don't know why any sane person would follow the forecasts of the banks on interest rate trends. As our beloved Reserve Bank Governor reduced the Official Cash rate to 2.5 % last week, all of a sudden the so-call banking Experts are urging Homeowners to fix their mortgages now to make the most of record-low interest rates which these Experts say are at rock bottom.

Take these examples from last weeks NZH: ’BNZ director of retail and marketing Craig Herbison said, “homeowners stood to miss out on years of savings if they didn't take advantage of the lower rates, which had likely reached their plateau.’”
or
Loan Market mortgage adviser Bruce Patten said, “further cuts to the cash rate were unlikely and now was the time to fix”.

But just hold on, what were the “Experts” saying just a few years ago?

I love this one from Nick Tuffley, Chief Economist at ASB Bank, back in August 2014, "We expect the second phase of the tightening cycle will take the OCR to a peak of 4.5 per cent in the second half of 2015." Wow, he was out by 40 odd percent in just 16 months.

He went on to say, "We expect short-term fixed rates to eventually settle near 7 per cent”. The reality is today I can wander into his bank and get a 12-month rate of just 4.39%. (conditions apply)

But let’s not pick on Nick. Forecasting interest rate trends must be difficult.
But how did his competitor at BNZ get on? The BNZ too, now tell us interest rates have, “reached the plateau”.
Rewind to November 2013, Tony Alexander of the BNZ had this to say, “With average floating mortgage rates currently around 5.8%, a 2 percentage-point lift in the OCR would see mortgage rates likely lifting by about the same amount, to nearly 8%.” Whoops he is out by 27%. So I am pleased I didn’t take his advice.

If someone wants interest rate forecasts they should go to a Fixed Interest fund manager such as Grant Hassell at AMP. Going to get advice from the big banks on mortgage rate directions is akin to what Warren Buffett said about barbers, “Never ask a barber if you need a haircut”

While you make some good points Stephen, you also miss a couple. I'll start with the recent headlines around Fixing. The recent comments about borrowers missing out on savings is not so much that fixed rates are going to move higher (i dont think they are) but more to do with the margin difference between fixed and floating rates that the banks charge. In the wholesale market there is very little difference between floating and the 1-3 year fixed terms. The difference you see in the residential mortgage market is mostly all down to margin taken by the banks. So... to your last statement, while I agree seeking independant advice, a banker saying fix now is only hurting his margins. If i was running a bank, I would want my whole book on floating, as the margin gained would more than make up for the fact that you are more at risk of losing it. If you are currently borrowing at advertised (or even discounted) floating rates, you are losing out every month to a lower fixed rate on offer (thinking about the 3.99% fixed rate at present).
In terms of where bank economists thought it was going.. almost everyone got it wrong. But you miss a very important point. The RBNZ provide forward advice on the direction of the cash rate. Its what economists use as the basis for their picks, and then adjust it if they think the RBNZ is too bullish or bearish on the economy. Back in 2013 and early 2014 they said they were going to raise the OCR to 4.5%. Indeed they were half way through doing it, then things turned. Maybe they got a little bit ahead of themselves, but to ignore guidence from them would have been irresponsible. Were they all wrong.. yep. Are they completely to blame.. i dont think so

Leverageup. There is a point you missed as well. Banks find it important that people fix, as that assists in locking people in as customers. Not a perfect tool, but useful to tie us in. They do not just decide on todays margin.
Getting new customers is seven times harder than keeping current ones. It's in their interest to get people to fix for terms.

Bravo.

Excellent, well said Stephen.
And most of us commenters have been at odds with the economists as we have been saying for years that interest rates were too high and would fall.

Also the RB's own forecasts from that date forward are shown to be a disaster.

The reservation I have is the fact that people are looking at a very short term - people are focusing on one or two years. This makes a mockery of people taking a long term view of their financial affairs.

this might be simplifying things a little, but as banks are businesses, trying to make a profit, surely its in their interest to get customers to fix in a falling market to secure a higher return and keep them floating in a raising market, again to secure a higher return....

Got to be time to be thinking about fixing for a long time, I was thinking that years ago at 8.6% because how much lower can it go ? but with rates in the fours its seriously cannot go that much lower can it ?

but why fix for a long time? There is little sign that the OCR is going to go up until well into 2017. But also just consider the NZRB was saying 4.75% OCR back in 2013/4. Now under 3% if not under 2.5% next year seems probable.

Fixing for 6 months if its cheaper than floating makes sense, but whats the logic or scenario that fixing long term makes sense?

rates in Scandinavia is at around 2-2.5%, with some even lower...

Yes.
I've said here before that i think we're on our way to European lows, and I still believe that.
We're too exposed to 2 markets: the Australian one and te Chinese one.
Australia and China are both slowing, for different reasons. Commodeties have collapsed, so the mining jobs in Australia have gone. And the rest of the world is no longer buying as much of China's exports as they would like us to.
The Chinese workforce is also not getting any cheaper.
Australia's slowdown means we will see strong immigration for a while yet, until Australia manages to steal all our service jobs (there are lots of companies starting to close down or minimise NZ operations, and moving it all out to AUS - economy of sclae makes it cheaper even with the higher wages in AUS). Australia has no qualms about playing the beggar thy neighbour game.
So - we will seee low wage inflation due to strong immigration, and once the jobs go this will put even more pressure on wages. Until the immigrants start leaving again.
Our exports are in the doldrums.
We are relying on tourism to keep us afloat, but I can't see that being sustainable for very long....
.
Anyway
Low interest rates for a while. yet.

What is being said about interest rates is exactly the same with the American economy.
They have been saying for years that the American economy is getting stronger and the FED will raise interest rates.
The economists and Finacial reporters are totally out of touch with reality.

They have been saying for a few years now that the low interest rates would kick start the economy. It has'nt worked but they keep saying it.

a) When they raise rates it kills the economy.
b) Its relative, if you dont drop it enough at best you stop the slide into deflation.
c) Longer term the financial sector is causing havoc with mis-allocation of cheap Fed money, yet no one wants to stop it as there is no other game in town.

that only works if most of the population are homeowners with mortgages and the extra money goes into their pockets to spend in the shops. NZ used to have 74%
we now have more renters than homeowners so they get no benefit of rate cuts infact it works against them as investors push up house prices and rents follow
the oldies that spent that interest get no benefit so they cut back on their spending
The OCR is slowly becoming less and less effective as our economy changes.
they may have to look at other measures to boost the spending in the economy i.e RB asking the govt to increase its spending

You have
An ageing population
Technology taking over jobs
Inequality
High debt levels
And they expect people to borrow and spend to get the economy going
Dreamers.

Harbinger, not harginger

Harginger sounds tasty.

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