Mortgage rate strategy 2014 - Part II

Road signs both saying Rates

The next Reserve Bank Official Cash Rate (OCR) announcement is on 24th April 2014. We will almost certainly see another 0.25% increase in the OCR to 3.00% on that date. If you'd like to fix your mortgage and feel you have missed the boat, then give us a call.

Whilst mortgage rates will increase, that doesn’t mean fixing your mortgage long-term is the best strategy. Tony Alexander from BNZ suggests he would fix for 3 years at 6.29%. Similarly we are fixing a lot of clients for a combination of 2 and 3 year fixed, but mostly so they relax and do more productive things than constantly ponder mortgage rates, which is a national pastime. The best advertised 3-year rate is 6.20% by SBS Bank who we deal with a fair bit. Above 7.00% the 4-year and 5-year rates are too expensive to warrant fixing, unless you need certainty. SBS has the best advertised 5 year rate at 6.85%. Based on how we think mortgage rates will track anything between 1 year and 2 year fixed looks good. Fixing the mortgage postpones the impact of future OCR increases. And that’s the point, fixing doesn’t avoid higher rates; it simply offers a temporary reprieve. Most Kiwis will only fix for 2 years, which isn’t that long, so any benefit from fixing is short lived. Future rate increases are already priced into the term structure of interest rates. The 2-year housing rate is higher than the 1-year housing rate because rates are expected to increase. Based on the current term structure, the break-even 1 year rate tracks as follows:

  Now In 1 year In 2 years In 3 years In 4 years
Implied 1 year mortgage rates 5.25% 6.75% 6.90% 8.30% 8.30%
JB's view 5.25% 6.25% 6.50% 7.00% 7.00%

If you don’t need certainty then the real question is: Will rates increase faster, or slower, than what is already priced into mortgage rates? For what its worth I expect rates to generally track below what the market is pricing in, making short term rates more attractive.

I think you'll be able to secure a 1 year rate in a year's time around 6.25%. To be better off fixing for 2 years than 2 consecutive 1 year terms the rate would have to be 6.75%. Mortgage rates are driven by three factors: (1) bank margins (2) swap rates and (3) credit spreads (bank funding costs.)

Swap rates are like fixed rates for banks and are also referred to as wholesale rates. Part of the reason I’ve been adamant that mortgage rates wont go up nearly as much as most commentators suggest, is that in a rising rate environment banks will compete away their margins. If you want early evidence of that, the 2-year swap rate is currently 4.10% and banks are advertising 2-year fixed specials at 5.95%. That is a gross margin of 1.86%. As a comparative, back in late 2012 banks had 2-year fixed mortgage rates of 4.99% but the wholesale rate was 2.66% (gross margin of 2.33%.)  Margins have already shrunk and we are only just getting started.

  1 Year 2 Year 3 Year 5 Year
Current mortgage rates 5.85% 5.95% 6.85% 7.40%
Swap rates 3.64% 4.09% 4.37% 4.68%
Gross margin 2.21% 1.86% 2.48% 2.72%
Current best rate 5.40% 5.90% 6.20% 6.85%
Who?  TSB  SBS SBS SBS
Swap rate 3.64%  4.09% 4.37% 4.68%
Gross margin  1.76%  1.81% 1.83% 2.17%

The Reserve Bank is forecasting a further 2.00% increase in the OCR to 4.75% by mid 2015. 4.75% is still a very low OCR by historical standards.

The OCR is currently 2.75% and peaked at 8.25% in 2007. We still have a long way to go before you should panic about rates.

The last time we had an OCR near 4.75% was July 2003 during the Asian crisis. At that time the 2-year housing rate was the same as now at 5.95%. That was with an OCR 2.00% higher than today. By July 2004 the OCR had increased 1.25% to 6.00% and the 2-year mortgage rate was 7.25%. So an OCR 3.25% higher than today, and also in a rising rate environment, had a 2-year mortgage rate only 1.25% above today’s rate. It is simply wrong to assume that a 2% increase in the OCR will translate into a 2% increase in fixed mortgage rates. As interest rates increase the yield curve (term structure of interest rates) will flatten out. Fixed rates will not increase as much as the cash rate. With an OCR forecast of 4.75% within 18 months, it will still be low (especially compared to its peak of 8.25% in 2007.) We are a long way off seeing a mortgage rate above 8.00%. What is important is the extent to which the Reserve Bank revises up its OCR forecast and to what extent it continues to increase above 4.75% in the latter part of 2015 and into 2016. How will we fare beyond 2015? This is where my various blog posts about kicking the can down the road come back in picture. The global economy is not fixed at all, and I think rate increases and a high exchange rate will quickly kill off any growth in the NZ economy. That's why we’re in for a long period of uncertainty and lower than normal interest rates.

As for Confidence at record highs pointing to a strong recovery, I'd imagine Lemmings are at their most confident just before they jump off a Cliff!

Confidence is a reasonably short-term measure. My view is that we will see mortgage rates increase quickly for the next 12 months partially driven by the Reserve Bank and partly driven by consumer panic. In the short-term there is a lot of euphoria to pass through our economy. Ultimately rates will settle down, maybe even decrease a little. At the very least a 2 year fixed rate now, will get you through this volatile period. Who knows what sort of craziness is install for us in 2015-2016. Anyones guess, but you'd be a Lemming to think that the world economy is in a beautiful space.