What's in store for interest rates in 2011 - the big questions, and some answers

By Roger J Kerr

Here are eight interest rate questions to ponder over the beach, beer and BBQ holiday period.

1. At what point in time will the RBNZ be forced to change the pessimistic tone to their economic outlook?

I would say about April; however every other commentator has moved their timing to “the second half of the year”. Waiting for absolute confirmation of inflation producing economic growth is no way to manage monetary policy – you will always be behind the 8-ball and cause too much collateral damage with subsequent rapid tightening action - that is, the NZD spiralling up and thumping the productive export sector once again. When will they learn from past mistakes?

2. Are the RBNZ on another planet to the rest of us when they voice surprise that the “low” interest rates have not stimulated the economy as much as they thought it would?

SME’s and households are paying higher credit margins over the banks’ cost of funds. One major Australasian bank was paying one of our investor clients 5.30% p.a. for a 12-month deposit for $1m last week. The OCR at 3.00% and 12-month wholesale swap rates at 3.40% are completely irrelevant to the vast majority of players in the economy.

The banks’ costs of funds are closer to 5.00%, as I have repeatedly stated all year. Doesn’t the RBNZ understand that the cost of money (interest rates) is where borrowers and investors meet on price and transact – Economics 101.

3. Will holding official OCR rates so far below true market interest rates be problematic for the RBNZ in 2011?

Yes, I think so. One can certainly envisage the situation in mid-2011 of Mr Bollard raising the OCR in 0.50% bites from 3.00% to 5.00%, however it having no impact on the economy, or borrower or investor behaviour (as they have been dealing at 5.00% for 12 months already).

All that will happen is the NZD will appreciate as New Zealand will be the only country in the world increasing official interest rates at that time. Thanks Alan! - you created this OCR pickle, now you find a way out that does not upset our GDP growth over coming years.

4. Who would have picked the US Government 10-year Treasury Bond yields to increase to 3.50% from 2.50% over the five weeks after the Fed Reserve announced their massive bond buying programme in QE2?

Well – I thought long term rates would increase as it was a classic “buy the rumour, sell the fact” outcome in the bond market. The increase in our long-term swap rates over recent months should have been of no surprise to borrowers. The US bond market is currently pricing in a stronger US economy and associated higher inflation over coming years.

5. From which parts of the NZ economy will the inflation come from in 2011 and 2012 that will require “tighter side of neutral” monetary policy settings to contain it?

Certainly not from excessive demand in the retail and housing sectors that the RBNZ are pre-occupied with. As always, the price increases in the economy will be local government rates, electricity, insurance premiums, commodity/food prices and energy prices. Do higher interest rates/higher currency value influence price-setting behaviour in the aforementioned? No!

6. Will PM John Key and Finance Minister Bill English react to the RBNZ Governor’s veiled threat that monetary policy can be looser for longer in 2011 if fiscal policy is tightened in the May 2011 budget?

If you were our Finance Minister would you slash Government spending/social assistance programmes in an election year? I don’t think so.

Mr Key and Mr English are relying on 3% plus GDP growth to correct the Government’s finances. My summation is that they will be correct to rely on that and shouldn’t listen to the Governor if they want to be re-elected. Make the unpopular economic policy decisions at the start of the second term is more appropriate advice to the PM and Finance Minister.

7. Will the banks increase deposit and lending interest rates in equal amount to the 2.00% increase in the OCR from 3.00% to 5.00% next year?

No! The banks are flush with cash with the slow credit growth and the large corporate borrowers have gone to the USPP debt market and are repaying bank loans. If the banks are not lifting their lending volumes next year, they are hardly likely to take in more money at higher deposit interest rates.

8. Will borrower’s credit spreads/margins continue to decrease?

Looks like they will reduce further with the big corporate boys getting their long-term debt from the USPP market at lower margins than local bank pricing. The way will be open for second-tier corporate borrowers to offer corporate bonds in the NZ domestic debt market to Mum-and-Dad fixed interest investors next year. This leaves the banks’ only lending to the “no-growth” home mortgage market and SME’s. The natural consequence is a lowering of fees and margins to sign-up corporate commitments.

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 * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com