Brother in law's guide: Fix long if you need to, but the urgency has passed

By Bernard Hickey Here's the short version: Reserve Bank Governor Alan Bollard took the unusual step on April 30 of saying he would keep the Official Cash Rate under 2.5% until late 2010 because the recession will be long, possibly well into 2010. This has taken some of the steam out of the recent rise in longer term wholesale mortgage rates, which then drove up longer term fixed mortgage rates. Therefore, the urgency to fix long before longer term interest rates rise has waned. Home borrowers can afford to wait on a relatively low floating or short fixed rate (6 months). But it would pay to be ready to fix quickly if rates start rising again, which may not be until next year. Another approach is to split the loan into a fixed component and a floating component, which allows the homeowner to hedge their bets somewhat. Bollard has changed his mind twice in the last 6 weeks and 18 months is an awful long time in this volatile economy. Here's the long version: Back on March 12 I argued in the previous brother in law's guide that home owners who wanted to fix should fix now because longer term mortgage rates were likely to rise. That was because Reserve Bank Governor Alan Bollard had commented that he didn't want to push the Official Cash Rate much below 2.5%. He seemed to set a floor for interest rates and suggested the rates cycle was nearing its trough. He said back then he expected the New Zealand economy to bounce back reasonably strongly in the second half of 2009 because there had been so much fiscal and monetary stimulus pumped into the economy. Bollard also commented that he saw a "˜very nasty' global inflation problem in years to come because of all the monetary stimulus and money printing going on in the Northern Hemisphere. His comments were more "˜hawkish' (in favour of rate increases to stop inflation) than many had expected.

I wasn't the only one that said it was now the time for fixers to fix. The resulting rush to abandon variable rates and go to fixed mortgage rates was astonishing and it surprised many in the banks and in the markets. Longer term wholesale mortgage rates rose as banks jumped in to hedge their risks for two to three years out to match the demand for longer term mortgages. As we predicted, average longer term mortgage rates rose from under 6% to over 7% as, naturally, the market reacted to the increased demand by putting up wholesale rates, or swap rates as they're known. This was not what Alan Bollard wanted because it effectively tightened monetary policy and threatened to stall any recovery, particularly in the housing market. So on April 1 he said these higher long term wholesale rates were out of step with his expectations. This appeared to calm down the markets and at least stopped rates rising any more, although they did not fall back to their pre-March 12 levels. Fast forward six weeks to April 30 and Bollard has effectively changed his stance from March 12 dramatically. He said on April 30 the global economy had worsened significantly since March 12 and business confidence remained very weak in New Zealand. He said he now saw a significantly longer period of recession with a slower recovery and weaker inflation, which was why he could cut the OCR by 50 basis points to 2.5%. Then he did something extraordinary. He effectively promised to keep the OCR at or below 2.5% until late 2010. My initial thought when I saw it on the statement was that it was a misprint. Bollard was effectively putting a ceiling on the OCR at record low levels for almost 18 months. He is essentially trying to keep long term interest rates low, at least for the next 18 months. This had an immediate impact, although it was relatively muted and the swaps rates have not retreated to where they were before March 12. So what does all this mean for my brother in law? It's worth looking at whether mortgage borrowers who are rolling over in the next couple of months should float or fix, and if they fix, for what period. This question of whether to fix or float and how long to fix is actually quite a complex question. It requires a view on where the OCR is heading, what is happening to wholesale interest rates and what profit margins the banks may choose to impose on top of these wholesale rates. Essentially, it requires a view on the likely state of the global and New Zealand economies, along with an idea of the stability and profitability of the banking system. Individuals will also have their own situations to consider. If a lump sum is expected in the near future such as a bonus, redundancy payment or inheritance, it can make sense to go variable rather than fixed, even if the rate is higher because debt can be paid down early to save money. Or it may make sense to fix even though the cost is higher because a borrower wants certainty about their outgoings. Everyone's situation is different. This analysis is aimed at a "˜typical' mortgage borrower who wants to find the lowest mortgage servicing costs for the forseeable future. I fit into that category, having a sizeable mortgage over the house I live in, so this counts as an analysis aimed at myself and for my proverbial "˜brothers-in-law.' So I'll call it the brother-in-law's guide. Now the caveats are out of the way, let's start. OCR may trough at 2% I thought after the March 12 Monetary Policy Statement that the OCR was likely to trough around 2.5% by the middle of this year, mostly because Alan Bollard told us he couldn't cut rates much below the 3% in place then because New Zealand needed to "retain our competitiveness in the international capital markets." This was code for saying New Zealand's exposure as a heavily indebted nation under threat of a credit rating downgrade meant any further cut in the OCR could trigger an exodus by foreign investors. Now he is saying the OCR could fall below 2.5% in small increments and in the April 30 statement he made no mention of the "international competitiveness aspect." However, in the press conference he said his views on "international competitiveness" had not changed. Most economists are saying the OCR is likely to be cut again in 25 basis point slices each on June 11 and July 30, which would take it down to 2%. But will this be enough to push mortgage rates lower? Variable mortgage rates are likely to be nudged a bit lower and 6 month rates, which are the main competitive battleground at the moment, are also likely to be cut a bit. But it's very debateable how much the 1,2, 3 and 5 year mortgage rates will be cut. The banks face intense pressure on their funding costs on both the international wholesale funds they have borrowed in recent years and the local term deposits they are competing aggressively for. Bank profit margins on net interest are actually falling, rather than rising, meaning the banks are very reluctant to cut mortgage rates. Results this week from ANZ and BNZ confirmed this. The swaps rates on domestic wholesale markets for 1 year debt fell only 30 basis points after the April 30 statement. The deathly silence from the banks in the 36 hours after Thursday's rate cut is telling. Only Westpac has cut its 6 month mortgage rate to 5.39%, which is now the lowest rate in the market. The banks may be waiting for a couple of days, but it's possible that they could sit on their hands. Either way, any cuts to the longer term 1,2,3 and 5 year rates are likely to be small. Having it both ways Anyone who values the certainty of a longer term fixed rate is probably safe to fix now, comfortable in the knowledge that these rates have fallen about as far as they can. It is possible that shorter term fixed rates and variable rates could fall a bit more, but probably not that much more. Variable mortgage rates (see all the rates here) may drop closer to 6% by late 2009 from around 6.4% now and could easily stay there until the end of 2010, given an extended recession followed by very limited growth. The 6 month rates may fall to around 5.0% and stay there until late 2010 from around 5.5% now. However, longer term 2,3 and 5 year rates are likely to stay in their current 6% to 7.5% range for the next year or so, as long as growth and inflation doesn't explode on the global stage. My gut feel is that the global economy is in for a deep recession through 2009 that could easily extend into 2010 in a milder form. New Zealand's recession could easily extend through until mid 2010, with the earliest signs of a recovery being accompanied in very late 2010 by an increase in the OCR. It may be more sensible for those worried about the OCR dropping dramatically lower to 1.5% to split their mortgage two ways. Having a good chunk in a variable or 6 month rate and the rest in a 2 or 3 year rate can hedge your bets.