Bernard Hickey looks at whether to fix or float and how long to fix as the Reserve Bank looks to cut the OCR again later this year and as the banks refuse to pass on lower wholesale rates

Bernard Hickey looks at whether to fix or float and how long to fix as the Reserve Bank looks to cut the OCR again later this year and as the banks refuse to pass on lower wholesale rates

By Bernard Hickey

Could mortgage rates have finally bottomed out? That's the question many are asking, despite the Reserve Bank cutting the Official Cash Rate at least twice and possibly three times in 2016.

The answer is important for those thinking of whether to fix or float their mortgage. Normally, the prospect of further falls in the Official Cash Rate (OCR) makes floating more attractive than is usually the case because floating mortgage rates are usually cut in line with the OCR cuts. But this time the banks are taking a different approach to cuts in the Official Cash Rate.

The Reserve Bank has cut the OCR twice or by 50 basis points to 2.0% in 2016, but banks have only passed on about 30-35 basis points of those cuts. That's because they say their overseas funding costs are increasing, although there's debate about that, and they say they can't pass on all the cuts to term depositers.

Savers are not growing their term deposits quite as fast as they used to, which means the banks have to work a bit harder to ensure they get the funding they need to keep growing mortgage lending. See more here from David Chaston on term depositors benefiting a bit from the banks not passing on all the OCR cuts to them.

The Reserve Bank also forces the banks to have a certain percentage of their funding from long term overseas bond issues and from local term deposits so they don't get burnt again by a freeze on international 'hot' money markets like they did in 2008/09. That in turn forces them to go after term deposits with higher interest rates than they normally would.

There's a couple of other things upsetting the usual bank behaviour this time around. The Reserve Bank is reviewing capital requirements for banks and many think the Reserve Bank will require the banks to hold more capital against their riskier mortgages to rental property investors. That would mean the banks have to put some of their profits aside as capital, rather than pay it out as dividends to shareholders. In preparation for these higher capital requirements from Australian and New Zealand regulators, the banks believe they need to build up their profit margins to put aside that capital. One way to build up their profit margins is to not pass on all the falls in the OCR and in wholesale interest rates to mortgage borrowers and term depositers alike.

Bank net interest margins had been easing back a bit in recent years as they competed a little bit harder for new business and as borrowers moved from more profitable floating rate mortgages to less-profitable fixed rate mortgages. But that fall in margins looks to have stopped and the banks now want to build up their net interest margins and profit stocks again ahead of these new capital requirements.

The end result of all this is that, for example, two year wholesale 'swap' rates have fallen 67 basis points to 2.09% this year, while the two year average advertised mortgage rate has fallen just 22 basis points to 4.4%. To be fair to the banks, the specials the banks offer of around 4.3% for owner-occupiers with deposits of more than 20% are better, but they also haven't fallen nearly as much as wholesale rates have fallen in recent months.

That's also despite the Reserve Bank signalling on September 22 that it planned to cut the OCR at least one more time in 2016, and possibly once more in early 2017. See more in my OCR report on September 22.

So the equation is slightly different to the normal situation, but not different enough to change the relative attractiveness of fixed mortgages vs floating. The bank's discounts on fixed mortgages, particularly shorter-term ones, mean that fixed mortgages are still more attractive than floating rate deals, particularly now the banks are not passing on all the OCR cuts.

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 terms than longer terms because it allows me to take advantage of refixing at a lower rate reasonably soon and be 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 normally seem to make more sense if rates were to fall, the cheapest and 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 last year when lots of people thought interest rates had bottomed out and would bounce, 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 since 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 slide in fixed mortgage rates over the last 18 months has made it much more difficult to justify paying the 5.60% 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 0.5% percent, but it has talked about it now for years without actually doing it. Some think there will finally be another US rate hike in December, but there remains plenty of doubts about whether rates will actually rise much at all. There may be one more small hike and then a long pause.

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. 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 5.65% 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 bank economists forecast, interest rates are cut again over the next year.

OCR rate by late 2017 One year fixed (4.3%) Two year fixed (4.6%)
OCR at 1.5% (low) + NZ$6,477 + NZ$7,458
OCR at 1.75% (middle) + NZ$9,272 + NZ$10,283
OCR at 2.0% (high) + NZ$12,379 + NZ$13,389

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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"Fixing for one year would give you the biggest benefit and the most flexibility to fix again at a lower rate if, as bank economists forecast, interest rates are cut again over the next year."

While I agree with most of the article, I don't agree with that statement. Fixed interest rates are, by definition, forward looking. If the rate cuts are behind you in a year, there's every chance the yield curve will be steepening, pushing longer term fixed rates higher. You would likely get the best fixed rates leading up to the predicted OCR cuts, as the market has a tendency to project ahead in straight lines - it's not a good idea to wait until after the corner!

I think there is limited downside to fixed rates from here, with an increasing risk of a bounce in the next few years, so have just fixed 2/3 of my homeloan for 3 and 4 years.

cheers rjn1.

All good points, however you're essentially saying there is an 'increasing risk of a bounce in interest rates in the next few years'.

Have you heard that before in the last 8 years? The RBNZ has twice had to reverse cuts and has repeatedly said it will have to 'normalise' rates at some point, along with every other central bank. The RBNZ is projecting falling OCR rates for the next year at least and then flat after that for the foreseeable future.

I think it's worth challenging your view that rates will rise and the curve will steepen.

The danger with flat or lower rates for longer that you miss out on the potential for yet lower rates in a year or so when the RBNZ cuts again. The RBNZ has scenarios to cut the OCR below 1% over the next year and at some point the banks will have put enough capital aside to start competing harder again. After all, they are the most profitable banks in the developed world and are about to increase their profitability again because of the margin expansion they have built in over the last 6-12 months.



G'day Bernard

Thanks for your reply - points well taken. I guess I'm looking at it as more of a balance of risks in the context of my own risk profile. If I consider how much lower retail interest rates can (or are likely to) actually go and weigh that against the premium I'm paying to stay floating, I'm comfortable giving up potential further cuts to lock in the current pricing. As you say, if you really are confident of rates staying low for the foreseeable future, the use of shorter term rates gives you the best of both worlds but of course increases your exposure to the unexpected scenario that inflation does suddenly reappear - the potential gains from this strategy don't seem to balance the risks for me.

What does seem clear, looking at comparison rates from across the ditch, is that our main banks seem hell-bent on keeping a floor under mortgage lending rates. I'll make this prediction: we won't see advertised retail mortgage lending (comparison) rates stabilise below 4% in the next 5 years.

Keep up the good fight, cheers.

Could mortgage rates have finally bottomed out?

Nope, that isn't how the ponzi works. Interest rates go down, prices correspondingly go up, and it all keeps going until it breaks.

A key for me in recent months is the realisation that houses are a financial asset not a home. I would define financial asset is anything that demands a yield, which includes money itself. The rule of money is that an excess of supply will drive the price, or interest rate, down. So while our money supply keeps growing at 7%, more than double the rate at which economy requires it (GDP at 3%) then the price of that money will keep going down. As will the yield on all related financial assets.

It also means prices will keep going up, which locks out new entrants as they struggle to put together a deposit in a low interest yield investment environment. With new entrants the scheme breaks, and the flow will go out of housing in search of a yield in other financial assets.

Question is what happens when interest rates get to zero, or negative, which they will in New Zealand like they are elsewhere in the world.

Which would all be true, and probably would already have been borne out except for the foreign money in the market and immigration. I believe just ridding the market of foreign buyers would have a decent impact and should be done asap, should have been done several asaps ago.

I think the money flow are so vast that is is beyond the governments comprehension, or ability, to stem the flow. But yes, some attempt would be nice.

Scarfie says: "A key for me in recent months is the realisation that houses are a financial asset not a home"

Take my comments as fine tuning of previous work I have done and describing the mathematical model that has predictive value. I have been posting on these issues here a lot longer than you have been around, so you can't know the nature of my previous work. Back in early 2013 I reworked the quantity theory of money to accommodate interest. (M.V)+i=P.Q. (Bernard received a copy) Back then I predicted interest rates would fall, and for NZ I was temporarily wrong. But it is the long term trend that is important, and it is still firmly down with nothing in place to turn them around.

Now I can say that financial assets conform to the reworked Quantity Theory of Money, so the same predictive value applies. Anything with a yield.....

Interestingly I found an old piece this morning that I wrote for friends back in 2013. It is about houses become money. That refers to shadow banking, and how the FED monetised houses by buying MBS's.

Strongly disagree Scarfie - if you understand the reasons why NZ will always have to pay a spread above the global benchmark, US rates, (e.g NZ has a greater credit risk, it's non-self funding, has only a small ilquid market etc), then for NZ rates to go negative you're really suggesting that US rates will go below negative 1%. Although you can't completely rule out anything in this now disfunctional world, with sentiment starting to now strongly question the growing set of risks around the small negative rates that currently do apply in many countries, I see close to zero chance of negative US rates - sure in a crisis they will start cutting again, and revert to QE however distasteful they may have found it, but negative US rates, let along negative 1% ? Nope, extremely low chance if any!,

Grant, I am saying it is a mathematical certainty, compound interest builds up as a portion of your money supply. It will come sooner or later to all countries. The only alternative is default on the debt, which could happen before we, or the USA, get to negative territory. So yes you are right, New Zealand may not hit zero, but then again we might. Keep in mind that I am saying there is that there is an inverse relationship to financial assets (house prices) and yield (interest rates). When retired folk no longer earn the yield they need to live on what are they going to do? Sell down assets is what, in a market where there will be lots of sellers depressing the price.

Charles Hugh Smith makes a good explanation of the effect.

They are a financial asset but first and foremost should be regarded as a home and any rules/regulations around them should be to primarily acknowledge that. The only reason people are seeing things the other way around is that rules/regulations make it so. It is wrong.

The part that really irks me , is the sheer profiteering by the Banks in the current economic climate . The RBNZ provides overnight (and longer) funding to the commercial Banks at the OCR , so the margins made by the Commercial banks on the funds sourced from the RBNZ, ( and savers) are massive compared to what they were before the GFC.

When the OCR was 7% , the mortgage rate was 9% allowing the Banks a 128% margin on the sum borrowed , now the OCR is 2% and the mortgage rate is 5%, so the margin is 250% .

Nice !

Basically that banks use something called WACC ,( see wiki ) which is the average of all their capital they have "borrowed" for lending , including the OCR funded portion , TD's , short term deposits and cheque and savings account deposits , and the carry trade funds ( often in TD'S )

Currently I estimate their WACC is around 2,1% to 2,5% for the big banks

Is it any wonder the banks are so keen to lend , almost recklessly , on "secured" assets like fixed property when the margins are in the super-profit league ?

Its therefore also little wonder the banks are reporting record profits and dividends to their parent Companies in Australia.

Don't think those margin calculations are correct. The margin is 2% vs 3%

Massively incorrect Boatman - you're completly missing the fact that banks are no longer able to fund at little or no margin over wholesale rates as they did pre-GFC. Their funding costs are now anywhere from 70-120bps over the curve hence which why is your numbers are well wrong - check out their reported spreads in their financials as it will show you no such margin move and that's the major reason.

Will Chon Kee come out of denial and manipulated lies and act . World over government are taking action against speculators and foreign non resident buyer but not our PM. Vested interest prevents him to think of the people of NZ . As he moves and is comfortable in speculative environment, is only able to identify and think like one as a result NZ is being ruined in the name of prosperity.

Seriously if Singapore can control it why not NZ

The Big Four banks in New Zealand are facing a shortage of term deposits, relative to stronger growth in demand for new lending. The Official Cash Rate is irrelevant to them, because under the Reserve Bank's 'Core Funding Ratio' regulatory requirements (see RBNZ website), banks cannot borrow from the Reserve Bank to finance lending. They must fund lending from either term deposits, or long-term wholesale funding. The cost of new long-term wholesale funding for banks has been rising throughout 2016 (for example the US PP market). So the big four are desperately trying to get term deposit money in by offering higher rates on term deposits, and they are not able to cut mortgage rates regardless of any OCR cut. The man on the street cannot borrow at the OCR of 2.0%, and neither can the big four banks for the purpose of funding lending.