'Why are 5 year rates higher today than 7 years ago, even though the OCR is lower today?'

A reader asks ...

"If the official cash rate is lower that it ever has been, why can I not find a 5 year fixed interest rate as low as I could 7 years ago when the OCR was actually higher?"

Our response ...

Fair question.

However the first thing to know is that the OCR does not set mortgage interest rates. It is the rate the RBNZ charges banks for short-term funding and it has a very large influence on the cost of short-term money in New Zealand. It is especially influential on the 90 day bank bill rate. And bank bills are what banks tend to use for wholesale funding between themselves. So, the OCR is the regulator's lever on the cost of short-term money for banks.

Therefore, it has a very big influence on floating mortgage rates, savings accounts and overdrafts.

Things are different for medium and longer term rates. Longer term fixed rates are largely determined by supply and demand.  For example, if suddenly a lot of people decide to switch their mortgages from floating to fixed, that raises the demand for longer term fixed rates and pushes rates up up.  Another influence can be international investors comparing long term NZ$ rates to say rates on long term US$ rates.  If US$ rates rise, then NZ$ rates look less attractive and so they will tend to rise as well.

When you boil it down, what really determines long term interest rates is the consensus view of all the people who are exposed to the risk of long term rates falling or rising and then expressing that view through demand and supply in the market.

But what drives that view? Simply put, it is expected economic growth, inflation and the response of the RBNZ to those two.  If the consensus view is that growth will be higher, it implies that there will be more demand from firms to borrow, less unemployment and higher prices.

In that scenario, the market will expect short term rates to rise over time as the RBNZ raises the OCR to choke off excessive inflation.  If short term rates are expected to rise over time, then longer term rates have to rise as well.

Why? Lets look at an simple 2 year example.  Start with the market expecting the 1 year rate to be constant at 5% per annum for the next 2 years.  In that case the 2 year rate will be 5% be annum as well.  If I have $100 to invest, and then I invest it for one year and then another one it will be worth $110.25.  And you would get the same if you invested it for 2 years at 5% per annum.

However if the market expects the 1 year rate to be 10% in year 2, then by investing it for 1 year and then another you would get $115.50.  So demand will shift from investing in 2 years to investing in one.  This will cause the 2 year rate to rise until you would end up getting $115.50 if you invested for 2 years.  That rate is 7.47%.

Seven years ago, when long term rates were lower than the OCR, it was because the market expected short term rates to be falling.

In addition, the recent global financial crisis has caused changes to the banking system that have pushed up banks' funding costs.

The RBNZ has added new regulatory obligations such as the "core funding ratio" and this is pushing up the cost of all money in New Zealand through those supply-and-demand influences. The "core funding ratio" is designed to prevent banks borrowing too much offshore and risking the credit worthiness of NZ as a whole - when money is cheap offshore, banks prefer it, but it leaves us exposed to real risks to our sovereignty.

Seven years ago, there was no "core funding ratio" and banks were shameless in chasing cheap funds offshore - they really loaded up with them and on-lent to mortgage borrowers in NZ at really cheap rates. It was a drug many homeowners willingly took. From 1999 to 2008 we went on an irresponsible credit binge. We all borrowed like there was no tomorrow. Houses, cars, overseas holidays, flat screen TVs.

Total household credit almost trebled from $59.5 bil to $174.9 bil. That is some binge! In other words, households (not businesses or farms) borrowed an extra $115 billion in those ten years. Government went on an amazing spending spree as well. Maybe because we saw government spending so freely (and without apparent consequence) we thought it was ok to do it ourselves?

Whatever the reason, it was amazingly irresponsible, and a price would have to be paid at some time in the future. It is a price our kids and young people will pay.

Well, that time is now. Those left with the mess have now to clean it up. The current lot will get blamed for the work they have to do, no doubt. But it is a job that can't be avoided now. Pain will be involved; unemployment, low growth, reduce public spending, reduced private spending, and no doubt inflation - which will make make it even more painful.

It won't make it any less painful to know that the NZ problem also happened in other western countries to a greater or lesser extent, over a lesser time period.

That is what happened, and why your mortgage seven years ago was cheaper then than now.

The lessons? 1: Pay off all debt as fast as you can. 2: Houses are not real investments. (The real estate boom was only an illusion.) 3: Never trust big-spending politicians. 4: Save, save, save because the future looks rocky. 5: We are going to be paying for the excesses of 1999-2008 for a long time to come, so get used to it (the faster we deal with it and take the pain, the sooner it will be behind us).

Probably more than you wanted to know; but, hey, that's my response to your question.

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"Houses are not real investments. (The real estate boom was only an illusion.).....We are going to be paying for the excesses of 1999-2008 for a long time to come.....Probably more than you wanted to know..." Now that's really how to answer a question, David!

They are higher today..and will be a good deal higher in the future because the banks know the fools who are on floating rates will soon receive a nasty surprise...the trickle making the shift today will flick to a flood. Then the banks will suck in the profits to balance the losses on the shabby loans they made in the bubble. It's a form of a bailout for the bank balance sheets. Those in debt will enjoy paying for the losses.

You say the same has happened in other countries i.e. UK and USA.  Why can you get 5 year mortgages in those countries for less than 4%?  I thought they were real basket cases.

Nicholas: Are you serious? I only wish I had brought more Real estate sooner and had never sold some of the great properties that I have owned. It will continue to be one of the safer investments that this country has to offer as long as you follow the basic and important fundamentals. 

and you are living by the quick sand fundimental that property cant lose money...


"If I have $100 to invest, and then I invest it for one year and then another one it will be worth $110.25. And you would get the same if you invested it for 2 years at 5% per annum."

That's assuming interest is paid annually. If it is paid at maturity, then your 2 year rate needs to be 5.125%pa.

The reader should google "yield curve" for an answer without the editorialising.

"Government went on an amazing spending spree as well. Maybe because we saw government spending so freely (and without apparent consequence) we thought it was ok to do it ourselves?"

Really? Govt debt went from about 32bn in 1999 to about ... 32bn in 2008. Govt debt held overseas actually declined as a % of GDP during that period.

Agree that household balance sheets got crazy leveraged during that time though.

You are right of course about government debt. But I was referring to spending.

In 1999 the government spent $35.8 billion. In 2008 they spent $73.4 bil.

They did that by increasing the tax-take for much of that period.

My point is that such a spending track was unsustainable. The govt did not borrow excessively; but perhaps to keep from feeling like they were 'falling behind' while paying those taxes, taxpayers themselves did the borrowing, and shunted some of those funds into tax-shelters like property. The 39% rate skewed behaviour significantly into sheltering strategies as well.

The government spending splurge fueled illusory 'economic growth'. It could never be sustained, and there would be (there is) pain when it ended.