Mother in Law's guide: Opt for up to one year and watch for guarantee action

By Bernard Hickey Here's the short version: Term deposit rates are edging up despite a flat Official Cash Rate  (OCR). That's because of hot competition between the banks for local deposits, but rates will rise even faster late next year as the Reserve Bank is forced to raise the OCR, possibly quite quickly. My mother in law likes to sleep at night so I'm suggesting she invests only for a 6-9 month term at around 5% to wait for higher rates late next year. She also needs to see how the extension of the government's deposit guarantee scheme from mid-October next year works out. Here's the long version: Every Tuesday from now on I'm going to review term deposit and debenture rates and examine the sorts of choices savers will have to make. Every saver is different with different personal situations and risk appetites, so I won't pretend to suggest a single option for everyone. Instead I'll talk about the things my mother in law needs to think about before making a decision. My mother in law is retired and supplementing her pension with income from bank deposits. She is conservative and anything I say is designed to keep my mother in law happy over the long term (ie to make sure she sleeps at night). The primary issue to think about is risk. How risky is any bank, finance company, building society or credit union? Does the return justify the risks? How much risk is my mother-in-law willing to take? So who's safe? Currently everyone with a government guarantee is safe until October 11 next year in that the government will pay deposits back all their money if the deposit taker defaults before that deadline. You can tell on our term deposit (up to 1 year) and term deposit (over 1 year) pages who has the guarantee by the blue tick. That October 12 date is crucial. Anyone who chooses not to participate in the extended guarantee scheme (which expires at the end of 2011) or is not accepted into the scheme shouldn't be trusted with my Mother in Law's money, unless they are a AA or better rated bank. If my Mother in Law was feeling a little frisky she could invest with an unguaranteed, subinvestment grade (BB+ or below), but should demand a very, very high yield and never, never put more than, say, 5% of her savings into that deposit taker. When I say very, very high yield I'd suggest no less than 10%. We don't know who will apply or be accepted into the extended guarantee scheme yet. We know that Treasury has said only BB or better rated deposit takers will be allowed in and anyone with a BB rating will have to pay a 150 basis point fee to the government. Any AA rated bank will have to pay a 15 basis point fee. This means there will be some banks who may choose to go 'naked' without a guarantee and rely on their strong credit rating. There may also be some finance companies and others who may choose to go 'naked' without the guarantee and choose to pass on some or all of the 150 basis points to their customers with a higher yield (and hope their low credit rating isn't noticed). Where are rates going? The secondary issue for any saver should be what is the likely return over the longer term and what is happening to interest rates. Term deposit rates from banks are governed by what happens in wholesale interest rate markets and by competition between banks for retail deposits, which has been hot lately. There's plenty of variables too inside the wholesale rate markets. For example, wholesale interest rates are effectively the market's judgement on where the Official Cash Rate (OCR) will be at a certain period in the future. The OCR, in turn, is decided by the Reserve Bank of New Zealand Governor Alan Bollard. His role is to keep the inflation outlook between 1 and 3% over the medium term. So traders and economists in these wholesale markets try to second guess Bollard on what he's thinking now about the growth and inflation outlook and what might happen in the future. The global economic outlook also has to be thrown into the mix because that can affect the New Zealand economy and sometimes cheap foreign money can flow into our wholesale money markets and push rates down. Another variable is New Zealand's sovereign credit rating. If it was downgraded our wholesale interest rates would rise. The longer the term deposit, the more variables come into play. For example, the Reserve Bank announced in June that banks would have to raise more of their funds locally and more of it at longer terms. This effectively pushed the banks to compete harder for term deposits by offering higher rates, sacrificing profit margins. Noone can be particularly sure either what the banks will want to do with their profit margins. They have been falling for the last couple of years. That may not last. Term deposit rates to keep rising, particularly long term deposit rates The OCR has been unchanged at a record low of 2.5% since April 30 and the Reserve Bank has pledged four times since then to keep the OCR at or below 2.5% until the second half of 2010. If the RBNZ sticks to its promise, that means the OCR, and therefore very short term rates (overnight to 3 months), are unlikely to rise until July 29 next year at the earliest, which is the first OCR announcement in the second half of 2010. However, longer term deposit rates have risen sharply since March and are in the unusual position of being substantially higher than the OCR. The big question for my Mother in Law is whether longer term rates will be overtaken by a fast rise in the OCR through late 2010. That depends on whether the global economy recovers quickly and New Zealand continues to recover quicker than economists were expecting earlier this year. I believe there is too much stimulus in both the global and local economies, which will force central banks to quickly tighten money policy from early next year, particularly in New Zealand where the housing market is bubbling again because of cheap interest rates. The risk to that view is if the global economy fails to recover quickly and stagnates. So what does that all mean? Given I think interest rates are likely to rise quickly late next year, I think it makes sense for my mother in law to park her money for up to a year to be ready for those much higher rates late in 2010. The other reason to wait is to see what happens with the extended government guarantee scheme. We'll know by the end of October next year who is in and who is out. We'll also have a much better idea of which finance companies and other non-banks have either leapt the species barrier to become a bank or have disappeared completely. What's around right now? Currently the best 6-9 month rates offered by banks is from ASB, which has 5% for 6, 9 and 12 months. The highest rate from a finance company is from South Canterbury Finance, which is offering a special 8% rate for a debenture maturing the night before the expiry of the government guarantee. I suggest my mother in law gets plenty of sleep by sticking with a AA rated bank. The government can be trusted to honour its guarantee, but it's not worth the worry and drama and potentially delay of a default and claim.