Brother in law's guide: Long term mortgage rates are rising again, so fixers should fix now (Updated)

(Updated on April 1 to include long rate hikes from Kiwibank and BNZ, a 6 month rate cut by BNZ, and RBNZ Governor Alan Bollard's warning about an "unwarranted" increase in long term wholesale rates) By Bernard Hickey Here's the short version. I see an extended global economic recession through 2009 and into early 2010 convincing the Reserve Bank to keep cutting the Official Cash Rate (OCR) to 2.5% by mid-2009, albeit in small chunks. This means we're near the end of the rate-cutting cycle. Longer term fixed rates bottomed out in late February and are now rising quite quickly all around the world as governments borrow heavily and central banks print money, increasing the risk of inflation. Those wanting to fix their mortgage rates long should do it now.But those expecting lump sums (redundancy/bonus/inheritance/Lotto) or are paying off their mortgage quickly should stay floating, given the OCR could stay low for a year or two. Here's the long version The Reserve Bank cut the Official Cash Rate on March 12 by 50 basis points to 3% and said it did not expect the OCR to drop below 2.5% because New Zealand needed to be competitive in international capital markets. This is code for: 'We can't cut rates too much more or international investors will stop funding our large foreign debts.' On April 1 Governor Alan Bollard said a jump in long term interest rates after that March 12 announcement was "unwarranted". Therefore, 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 now 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 to trough at 2.5% Firstly, let's look at where the Official Cash Rate will go over the coming 6 to 12 months, which is about as far out as anyone can sensibly forecast. I think a 2.5% OCR is likely by the middle of this year, which would see variable mortgage rates drop towards the low 5% mark by the 4th OCR announcement of the year on June 11. RBNZ Alan Bollard was unusually prescriptive on March 12 when he said the OCR was on a 'glidepath' towards a bottom at 2.5%. This surprised most observers who had previously expected a 2% trough and was much more 'hawkish' than previous statements about having plenty of room to cut. Bollard's tone was more upbeat in the March Monetary Policy Statement and more 'hawkish' about global inflation. He is more confident than most that significant rate cuts, big government deficit spending and the lower New Zealand dollar will power a 'fragile' recovery in the economy later this year and then quite strong GDP growth in late 2010 and 2011 (4.6% by early 2011). I'm a bit more pessimistic about the economy, but the strength of Bollard's comments on the OCR bottoming out no lower than 2.5% suggest that the end of the rate cutting is near. Wholesale interest rates also rose significantly on March 12 and have kept rising since. There are some caveats. Bollard said things could get much worse overseas, which could change his growth view. But I think the OCR view is unlikely to change, simply because we can't afford to offer lower rates to international investors. New Zealand is on notice from Standard and Poor's about a potential downgrade in its AA+ sovereign credit rating unless the government can get its forecasts of rising debt back under control. Even if Alan Bollard may want to take up more of the task of reviving the economy than Bill English, he can't. Variable rates have further to fall Secondly, we have seen an interruption in New Zealanders' love affair with fixed rate mortgages, particularly the longer term two, three and five year versions. One reason is the obvious attraction of variable or short term mortgages when rates are falling. After all, why lock yourself into high rates in a falling market. But it appears we have begun falling in love again in March. Banks are reporting many people are looking to fix again long as longer term interest rates rise. Ironically, this big rush to the exits was a factor in pushing up longer term wholesale mortgage rates even faster. There's also another powerful force at work. One of the reasons we fell in love with fixed rate mortgages is that our banks were able to get relatively cheap funding for them from very liquid international markets awash with money from the investment banking-led credit boom post 2002/03. Our banks would borrow for terms of one or two years for not much more than it cost them to borrow off each other on local markets. Now the Credit Crunch has destroyed the market for cheap, longer term funding on international wholesale markets and our banks are having to rely on relatively expensive local retail savers, or ruinously expensive international funding (if they can get their hands on it). The Reserve Bank is also pushing the banks to lengthen their funding maturities and borrow less offshore to reduce our vulnerability to the sort of financial market shocks we've seen in the last 18 months. The net result of these trends is that banks will not be able to offer vastly cheaper fixed rates than variable rates, now that variable rates are dropping. All banks have now lifted their 5 year mortgage rates to 7.5%or higher in the last three weeks from around 6% before March 12. Bank profits are under pressure too. The profit margins they charge between wholesale rates and their fixed mortgage rates will, if anything, rise further to compensate for higher bad debts. This will act to keep the pressure on longer term fixed rates to be higher than shorter term fixed and even variable rates. We are finally seeing a positive yield curve. This sounds like something only interest rate anoraks like me should care about. But it is actually a return to a much healthier set of credit markets and sharpens the power of the Reserve Bank's monetary policy immensely, although this rush back to fixed rates in recent weeks may blunt the rates blade somewhat. The weighted average time for fixed mortgages to refix has dropped to 12.5 months from a high of 19.9 months in August 2007. Bollard is helping to sharpen his axe by cutting rates so far and so fast that it encourages borrowers to move to variable rates. He could almost be accused of having an ulterior motive, and who would blame him for it. But long fixed mortgage rates are rising Long term interest rates are rising globally as investors prepare for a mountain of debt issuance by governments running up monster deficits to boost their economies. The US 10 year Treasury yield has risen from around 2% to 3% since the beginning of the year, which pushes up wholesale rate curves globally. The failure of a UK government bond auction on March 24 and a weak US Treasury auction on March 24 also hurt sentiment. New Zealand government 5 year bond yields have bottomed out at around 3.8% in the last couple of weeks and are nearing 5%. This is already flowing through into longer term fixed rate mortgages. ASB, for example, initially set a 5 year rate of 5.95% immediately after the January 29 cut in the OCR to 3.5%, but has raised it in recent weeks to 7.50%. My gut feel is that two and three year rates have bottomed out at 5.95%. All the banks have now raised their 2 year rates to around 6.2%. (Updated to include latest changes). If you need to fix your mortgage payments for years to make it easier to budget or you think short term rates will rebound quickly in the next couple of years (which they might) then fixing now for 2-5 years makes sense. Flexibility the key The final reason for choosing variable or short term fixed rather than long term is that it gives borrowers the flexibility to fix when they see that rates have bottomed out. Longer term fixers should know rates have bottomed out. Being on a variable rate means a borrower can fix at the very moment it becomes clear to people that rates are about to start rebounding. My pick at this stage is that the OCR will have to be put up again in late 2009 or early 2010 as the enormously stimulative effects of these low interest rates, a low New Zealand dollar and the government's fiscal stimulus of 3% of GDP fire up the economy. Central banks around the world are also pumping cash into their systems and in some cases just plain printing money to revive their economies. At some stage all this fuel is going to catch fire and interest rates will take off again globally as central banks try to take away the punchbowl just as the party is getting started. A UK Gilt auction failed on March 25 because of the extra supply and a US Treasury auction on March 25 was disappointing as fears grow that the Chinese have stopped buying Treasuries. Bollard said on March 12 he expected some "very nasty" inflationary pressures to build globally in the coming year or two. To find out what all the banks are offering, check out our mortgage rates table, which is the most comprehensive, accurate and up-to-date around. What's hot right now (April 1) (Please check the rates table for the absolute latest) The lowest variable rate at the moment is Kiwibank's 5.99%. The big banks are grouped around 6.40%, with BNZ, ANZ and National on 6.45%, ASB on 6.40% and Westpac on 6.49%. BNZ's 1 year "Classic" rate of 5.49% is the lowest one year fixed mortgage rate at the moment. To get the rate previously, a customer had to buy two other products from the BNZ, however this requirement no longer applies and the rate is now a product on its own. The lowest 6 month rate is 5.45% from BankDirect, while ASB is on 5.50%, BNZ is on 5.50%, ANZ and National are on 5.79% and Westpac is on 5.79%. ANZ offered a special 3 month fixed mortgage rate at 5.65% after the March 12 rate cut. The 2 year rates were all grouped around 6.2% to 6.25%, while the 5 year rates are now grouped around 7.5% and 7.6%. (Updated to include various increases). Again, please check our rates page for the absolute latest, but I will try to keep this fresh. A final note. I think this is what the RBNZ will do with OCR (cut it to 2.5%). This is different to what I think it should do (not cut it at all). I think it should keep the OCR high because we have a national savings problem that can only be fixed with less spending and more saving. Cutting interest rates encourages exactly the opposite. We also have a domestic inflation problem which will not be fixed with record low interest rates. If there is a complete meltdown on international credit markets, which cannot be ruled out most nights at the moment, then there is a risk the credit market vigilantes that killed Iceland will pick on other current account deficit culprits like New Zealand, Spain, Ireland and Britain. We could see the warnings about our credit rating turn into a full scale rout of the New Zealand dollar and a complete freeze on foreign credit. That could potentially force the Reserve Bank to put rates back up to defend the New Zealand dollar. That's what happened in Iceland. That is one risk that could blow my 2.5% OCR forecast out of the water.