Brother in law's guide: Seriously consider floating in the years ahead

By Bernard Hickey Here's the short version: It's now clear that the landscape for interest rates in New Zealand (and globally) has now changed for years to come. Variable mortgage rates are now likely to be significantly cheaper than fixed rates for long periods of time, long enough to make it worthwhile to switch to variable rates to consistently get the best deal. Some may choose fixed rates to be sure of their outgoings, but those looking for the cheapest rate for the longest period are probably now best off floating. This is a change to a landscape that has been in place for almost a decade. Here's the long version: New Zealand home owners have assumed for years that fixed mortgage rates are usually cheaper than variable rates and that choosing to fix is the default option. The only doubt in the past was for short periods at the margins when interest rates were falling fast or there was some temporary hiccup in the market. Sometimes borrowers would choose to float as rates were falling and then aim to 'pick the turn' and jump back onto fixed rates. But what if something fundamental changed that meant New Zealand's variable rates were usually cheaper than fixed rates for years on end? I've held back for months from even suggesting this given the New Zealand mortgage market's history for most of the last decade. We're a nation addicted to fixed rate mortgages, but I think it's now time to seriously considering floating for the long term to get a better deal. Reserve Bank Governor Alan Bollard said in the bank's March Monetary Statement (MPS) on March 11 that he now expected bank funding costs to remain elevated for a long time, partly because of increased competition for funds globally and because of moves by regulators to restrict access to the cheap 'hot' money that helped keep longer term fixed rates lower than floating rates in the past. The Reserve Bank estimated in its MPS that these higher bank funding costs had increased to about 150 basis points (1.5%) over the Official Cash Rate in the last two years, up from around 20-30 basis points before the global financial crisis. This extra cost has effectively been bolted on to the cost of fixed mortgages. As the chart above shows, fixed mortgage rates have been rising for over a year (see blue 2 year fixed line) while floating rates (red line) have been falling. So why has this happened and can it last? What was the shift in the tectonic plates of the financial world that turned New Zealand's yield curve upside down so it is now upward sloping? The simple answer is the Global Financial Crisis that started in March of 2008 changed everything and is still rumbling through the system. It could rumble for at least another 5-10 years. The previous structure of interest rates globally and locally was just not sustainable. Essentially, the US Federal Reserve dragged short term interest rates down to near 1% for much of the period after 9/11/2001, which encouraged many banks in the Northern Hemisphere to go on a lending spree, helped along by fancy new securitisation vehicles and aggressive investment bankers in Manhattan and Canary Wharf. This massively increased the leverage of many banks globally and swamped the world with 'hot money.' Some of that money ended up in New Zealand because our big four banks chose to fund a good chunk of their mortgage lending here from 2002 to 2008 by borrowing in those 'hot money' markets for short terms. Then the financial crisis hit and those 'hot money' markets dried up. Our banks got by through late 2008 and early 2009 with some help from the Reserve Bank, their parents in Australia and by slowing their lending. Not so much 'hot money' The markets are opening up again, but now regulators and Reserve Banks are keeping a tight rein on the banks. They are being forced to scale back their leverage and to borrow for longer terms so they don't have to rely on these 'hot money' markets so much in future. This is proving more expensive for the banks. The Reserve Bank of New Zealand was the first of the central banks to bring in a 'liquidity policy' which sets a target for the banks known as a 'Core Funding Ratio.' This specifies that the banks must have 65% of their funding from stable sources such as local term deposits or from long term wholesale funds. This ratio is set to ramp up to 75% over the next couple of years. This chart here from the Reserve Bank shows the extent of these higher funding costs and how they've increased. These increased funding costs are not going away.

Governor Bollard also made the point in the news conference that these pressures on funding costs will be around for a long time, particularly as competition for funds on global wholesale markets heats up. That's because governments are now borrowing heavily and often for long terms. That pushes up the cost of longer term wholesale borrowing, which many banks now need to use to keep their 'Core Funding Ratios' in good shape. See Governor Bollard talking about this in this video (around 8 mins 10 secs in) The world has changed But there's a bigger force underpinning all this pressure on interest rates and the potential for a long term turnaround in the 'typical' shape of the yield curve in New Zealand from being downward sloping (fixed being cheaper than variable) to upward sloping (variable being cheaper than fixed). This bigger force is the de-leveraging of high debt levels of the world's developed economies. New Zealand is one of those economies with high foreign debt and high household debt levels. Our net debt stands at 134% of GDP while household debt stands at 152% of disposable income, up from 98% and 99% respectively 10 years ago. That makes us among the most indebted countries in the developed world. Luckily for us, our international creditors don't care much because we are seen as suburb of Australia, which is seen as a province of China. But the pressure to de-leverage remains intense globally and we aren't immune. A recent study of 44 economies over 200 years by Harvard Professor Kenneth Rogoff and Maryland University's Carmen Reinhart found that when public debt to GDP rose over 90% that developed economies' growth rates slowed by 1% per annum. Their book "This Time it's Different" indicates that debt-fueled booms are inevitably followed by periods of de-leveraging that slow growth. One way that economies de-leverage is for interest rates to increase, reducing growth of debt and allowing the denominator (GDP) in debt to GDP to grow faster than the numerator (debt).  The Rogoff/Reinhart study shows periods of de-leveraging can last for years. A widely cited McKinsey report on de-leveraging found that periods of de-leveraging in the past have lasted six to seven years on average. This could last for years This is all a long way of saying that variable mortgage rates could remain lower than longer term fixed mortgage rates in New Zealand (longer than than 18 months/2 years) for at least three to four years, and possibly for longer. The pressures for higher bank funding costs (which keep fixed rates higher than variable rates) are widespread, deep, global and structural. They are being cemented in by regulatory action in both New Zealand and the rest of the world. That's why I think it's now time to seriously consider switching to floating rate mortgages for the long term. This may not be appropriate for all borrowers, given some place a high value on certainty for their mortgage payments. The problem for most will be that that certainty now comes with a significant cost relative to variable rates. Check out the rates The advantages of variable rates are now clear in our mortgage rates table. Variable rates are typically now around 5.65-5.75% for the major banks, while two year fixed rates are clustered around 7.1% to 7.3%. If, for example, the Reserve Bank starts increasing the Official Cash Rate from its 2.5% to around 5% by the end of next year, then variable rates are expected to rise to around 8-8.5%. Given fixed rates are also expected to rise by a similar amount to around 9-9.5% the choice is clear for those simply looking for the cheapest rate. The difference between variable and fixed is now so large that it is almost impossible for a borrower to 'catch up' by choosing a fixed rate over a variable rate and hoping to get their timing right. Previously, there was enough of a cushion for borrowers to punt and get it right. Currently, the absolutely lowest variable rate on offer is from Kiwibank and Westpac on 5.65%, with ANZ on 5.69%, National on 5.75% and ASB on 5.75%. The lowest 'fighting' fixed rates from the banks are 6.49% for 18 months from Kiwibank, 6.59% from BNZ for 18 months, 6.7% for 18 months from ASB and 5.99% from ANZ for 6 months. Your views? I welcome your comments and insights below