Bernard Hickey looks at whether to fix or float and how long to fix when the Reserve Bank is cutting interest rates and targeting Auckland property investors

By Bernard Hickey

Earlier this year most borrowers thought the next move in interest rates was likely to be up and therefore fixing for as long as possible made sense. Some people leapt at chance in February to fix for 10 years. Oh how the times have changed.

The decisions on June 11, July 23 and September 10 by the Reserve Bank to cut the Official Cash Rate by a cumulative 75 basis points to 2.75% and signal at least one more cut has certainly taken a few by surprise. Most floating mortgage rates were cut by the same amount and shorter term fixed mortgage rates have fallen more than 100 basis points over the last six months.

Average one year mortgage rates are down by more than 1.5% to around 4.3% in the last year. If you'd asked someone a year ago if that would happen, they would have laughed you out of the forecasting room.

Also, through the winter the Reserve Bank and the Government launched a pincer movement to try to slow house price inflation in the Auckland market, which Finance Minister Bill English has described as a "feeding frenzy."

The Government introduced a "bright line" test from October 1 that will assume that anyone selling an investment property within two years of buying it is doing so as a trader and therefore must pay income tax on any capital gains made over that period. The Reserve Bank has also announced it will restrict Auckland rental property investors to no more than a 70% loan to value (LVR) ratio from November 1.

Many borrowers who are buying property in Auckland or elsewhere will wonder how this changes their decisions about whether to buy and how long to fix, if they're not already floating.

The mid-May announcements of the 'bright line test' and the new Auckland landlord LVR restrictions appear not to have had much impact yet on property markets, particularly in Auckland where sales volumes rose over the last year to record levels and median house prices also marched on up to new records. Auckland house price inflation is running at an annual rate of 20-25%, whereas inflation elsewhere is closer to 5%, or none at all. The lower interest rates have softened any blows on the regulatory front.

Real estate agents and valuers even point to a pick up in activity in Waikato/Bay of Plenty as investors spill out of Auckland with plenty of equity and look to keep borrowing above 70% in those markets outside of Auckland. There are initial signs through late September and early October that auction clearance rates are falling as some buyers pull away from the market, but it has yet to feed through into the sales volumes and prices data.

The question for many will be whether the slowing economy, thanks to a slump in dairy prices and weak wage growth, starts to drag on house prices. Certainly that slowing economic outlook is helping the outlook for interest rates.

Weak GDP figures published on June 18 caused economists to slash their forecasts for the Official Cash Rate and most expect it will fall a further 50 basis points to 2.5% by early next year because inflation is so weak. Some even think it could fall to 2% and others argue it should fall to 1.5% if the Reserve Bank was really serious about getting inflation back up to the 2% level it is supposed to target. Annual CPI inflation was 0.4% in the June quarter.

Economists are divided on whether the Reserve Bank will cut again on October 29, with most saying the Reserve Bank will wait until its full December 10 Monetary Policy Statement before cutting again.

Independent forecaster BERL thinks the Reserve Bank should cut the OCR to 1.5%. See my article on that here.

So how does this fit into the decision fix or float?

My view for several years has been that interest rates stay lower and for longer than most economists have forecast. They may even fall more than some expect.

That makes me more likely to fix for a shorter than a longer term. The banks subsidise fixed rates at the expense of higher floating rates, so even though floating should make more sense if rates were to fall, the cheapest most flexible option is a shorter fixed mortgage. The idea of a 10 year fixed mortgage scares me witless.

That rate of 5.75% for 10 years might have looked good earlier in the year, but what if the long term average for mortgage rates is in the process of a structural fall to more like 4-5% instead of the 7.4% we've seen on average over the last decade? Imagine the break fees on a 10 year mortgage. As it turns out, TSB have already cut their 10 year rate to 5.75% and it is well above the 4.3% low rates on offer for one year fixed rate mortgages.

Could they go lower?

The slump in fixed mortgage rates has made it much more difficult to justify paying the 6.0% offered by most banks for floating rate mortgages. The question then is: how long to fix?

The answer to that question depends on your view on where inflation in New Zealand and globally is going, and what you think central banks will do about it.

The jury is in overseas. They are treating this very low inflation and deflation as a cyclical issue that needs to be addressed with even lower interest rates and money printing. The People's Bank of China has also eased monetary policy repeatedly in recent months, as has the Reserve Bank of Australia. The Reserve Bank of New Zealand was an outlier for all of last year.

Only the US Federal Reserve is talking about putting up rates, albeit from almost zero percent, but it has talked about it now for years without actually doing it. Some think there will finally be a US rate hike in December, but there remains plenty of doubts about whether rates will actually rise much at all. There may be a small hike and then a long pause. Long term bond yields have actually fallen in the last month on worries about China exporting deflation.

The global trend over 15 years has been for interest rates to fall ever lower. It's not just about falling petrol prices. There is now a growing debate about whether the deflation is structural and linked to changing technology, the globalisation of services and ageing populations. For now, central banks think it's cyclical. The wisdom of crowds in financial markets, particularly bond markets and stock markets, suggest it might be structural.

Structural or cyclical?

If it is structural then interest rates could remain low and possibly fall even further. Remember that interest rates averaged around 3% for all of the 1800s during the first age of industrialisation as new machines lowered the cost of production.

Some argue the world is entering a second age of industrialisation that delivers a similar type of 'supply shock' that lowers prices of goods and services for decades to come. The age of the smartphone has clearly driven down prices for many services, including shopping, accounting, music, telecommunications and taxis. Could we see many other areas such as education, health and financial services similarly transformed in a deflationary way?

Calculating the gains

There is a way to work out which mortgage and which rate saves you the most money, relative to floating rates. Interest.co.nz has built a special fixed vs floating calculator. See the table below for the latest calculations on a NZ$500,000 mortgage.

Here's a table that shows the benefits of moving a NZ$500,000 mortgage of moving from a floating rate of 6.0% to the various fixed options, assuming different interest rate tracks. The gains are indicated as a positive and the losses are negative. The middle track for the OCR is in line with market expectations. See all mortgage rates here.

The latest estimates, given the drop in fixed rates in recent months, suggest fixing is cheaper than floating across the board.