The Reserve Bank kept the Official Cash Rate (OCR) unchanged at its last announcement on the 30th January but is widely expected to increase the rate at its next meeting on the 13th March. Bank economists are in a lather of excitement predicting rates to rise over 2.00% over the next few years. The media has jumped on the bandwagon suggesting mortgage rates will go over 8.00%. Often there is confusion in the media, with them interchanging between OCR, wholesale interest rates and mortgage rates.
Interest rates and mortgage rates will respond differently to an increasing OCR. Here is what you need to know: The Reserve Banks OCR is an overnight interest rate, whereas fixed interest rates are for a fixed term and factor in anticipated rate increases. Fixed mortgage rates have already priced in future increases in the OCR. For long term fixed rates, any increase will depend on if the market believes rates will increase faster or slower than what has already been priced in. When interest rates are low, as they are now, banks struggle to reduce the interest rates they pay on deposits.
In New Zealand the minimum rate you can pay on a deposit is around 4.00%. This is 1.50% above the OCR. Banks are having to pay more for retail deposits than if they borrowed directly from the market. They have no choice. To safeguard our system, the Reserve Bank mandates that a certain percentage of bank funding is derived from retail deposits. In the current rate environment banks compensate for the negative margin on deposits by taking higher margins on mortgages.
As interest rates rise, deposit margins will bounce back. You won't see much of an increase in deposit rates as the OCR goes up. This increases bank profitability so you will see banks then gradually compete down mortgage margins. Mortgage margins are currently around 2.20% against swap rates (and have been as high as 2.70%.) These margins will fall to around 1.30% towards the top of the interest rate cycle. So, the key point that the media misses is that we wouldn't expect to see mortgage rates mirror increases in the OCR. A 2.00% increase in the OCR is likely to lift short term mortgage rates by 1.50% from around 5.00% to 6.50%.
The last dynamic to factor into how mortgage rates increase is that borrowers tend to gravitate towards the lowest rate. In a rising rate environment banks will run specials using short term fixed rates, particular the 1-year and 18-month terms. They will be prepared to write these at lower margins because this is where the competition is. From a borrower perspective lower margin means better inherent value-for-money.
DON'T PANIC ... mortgages rates are still a long way off getting to 8.00%
Whilst I believe we will see some increases in the OCR in the short-term, I think it will be short-lived and any looming wave of rate increases will dissipate into a mere ripple. You see, we cannot hide from a lot of the baggage we still cary post GFC. Kiwi households owe over $180 billion of mortgages and farmers owe another $50 billion. This is particularly scary if you think that we have a superannuation crisis somewhere on the horizon. Who is going to pay off all of this debt, save for their own retirement, and pay for the shortfall in their parents retirement. Holly shit I should put my head back in the sand! Where's that paper bag? In the short-term we could disconnect from some of these big imbalances, and New Zealand could have its own little party for one. That party might burn on for a year or two and we will need some OCR increases to sober us up. However, somewhere down the line we will run back into our problems. Recap important points:
- Mortgage rates won't increase at the same rate as the OCR
- Fixed rates already price in future increases in the OCR
- Short term rates tend to get priced more aggressively at lower margins (better deals)
What the above means is that short term fixed rates (in particular 1 year and 18 month terms) will out-perform longer-term fixed rates (3, 4 and 5 years) over time. You'd generally be better off financially by rolling a 1-year rate three times, than fixing for 3-years.
Implied Rates
With a bit of mathematics wizardry we can decompose mortgage rates to work out the implied future rates. The logic for how to do this is as follows. All things being equal, the 2 year mortgage rate should be equal to what I pay for a 1-year fixed rate now and then what I pay for a second 1-year fixed rate in 1 year's time. Whether I fix for 2-years or fix for two consecutive 1-year terms, both of those strategies should deliver broadly the same interest cost. The following table shows the market implied forecast for 1-year mortgage rates. I've compared that to my forecast of where rates will be. What you see is that I'm forecasting rates to stay lower and to increase slower than is being priced by the market into current fixed mortgage rates.
| 1 Year Rate Forecast | 2015 | 2016 | 2017 | 2018 | 2019 |
| Market | 5.25% | 6.75% | 6.90% | 8.30% | 8.80% |
| JB Forecast | 5.25% | 6.00% | 6.50% | 7.00% | 7.00% |
The second table shows what I consider to be my break-even rates. These rates are what I think current fixed rates should be for me to be indifferent to fixing short-term or long-term because the cost will be the same based on my forecast. It shows that long term fixed rates are out of the money.
| Fixed Term | JB | Market |
| 1 | 5.25% | 5.25% |
| 2 | 5.63% | 6.00% |
| 3 | 5.92% | 6.30% |
| 4 | 6.20% | 6.80% |
| 5 | 6.35% | 7.20% |
If rates increase as I'm forecasting then you will be better off (pay less interest) with short-term rates. You'll see from the implied rates that the market has priced the 1 year rate hitting over 8.00% in 3 years time. That would require a 4.00% lift in the OCR and not even bank economists have that in their forecasts. The mortgage isn't just about the interest rate and paying less interest. There are other considerations below that you may need to factor into your decision.
Emotional Factors
Short-term rates are more volatile. They also keep your mortgage top-of-mind which isn't a good thing. I often advocate fixing for clients so they don't have sleepless nights thinking about interest rates. From time to time you may need stability. For example, you might be planning a family, you might be adjusting to new costs - like school fees, you may be over extended. Fixing is the right thing to do if you are anxious about rate increases. If you want to fix longer term I think the best option is the 3 year rate.
Splitting
We almost always advocate splitting your mortgage into different parts and fixing them for different terms. With property investors this is an important part of portfolio management and making sure you're not too sensitive to rapid changes in rates. In a rising rate environment, having parts of your mortgage on different terms, or each mortgages on different terms, makes sure that any rate changes are gradual and easier to adjust to. It also reduces the pressure to "guess right" when deciding on a fixed rate.
Try and ignore Consumer Panic
In the early stages of rates going up expect to see some rapid increases in rates as everyone rushes to fix. This is a supply/demand issue and will temporarily detach mortgage rates from fundamentals. After a short while, rates will settle down again. Some of this has already happened with the 2 and 3 year fixed rates over the past 2 months, so there shouldn't be too much more to come. The tendency is going to be to want to fix when you see rates going up scarily. It pays to be just aware of what is going on.
Fixed Rate Rollovers
Finally, if you want us to look after your fixed rate rollover or to talk to one of the team about what you do give us a call on 09 376 9688 or drop us an email to support@squirrel.co.nz. We'll happily discuss your mortgage even if you aren't currently a Squirrel client.