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|