The 12 month rate fix (part 2)

Squirrel
1 November 2018
blog

12 Month interest rates are at all time lows for New Zealand, however it may not be prudent to fix over that term.

In part 1 we discussed:

  1. What is the Official Cash Rate and how is it applied?
  2. What is inflation and why is it important?
  3. The connection between interest rates and inflation.

In part 2 we’ll cover:

  1. Forward interest rates and how they are calculated.
  2. Current inflationary drivers in NZ.

I’ll then pull these five factors together to argue why I wouldn’t fix for 12 months.

What determines forward interest rates?

Forward interest rates can most simply be described as market sentiment of where interest rates are heading in the future. As discussed, interest rates are influenced by the OCR and the OCR is influenced by inflation.

Therefore, forward interest rates are reflective of future inflation. If we believe inflation is going to be high (and thus the OCR and interest rates raised), we would see the forward yield curve slope steeply upwards, and vice-versa.

The market is currently forecasting a small rate cut in the OCR with monetary policy expectations (as at Sept 3rd) forecasting an OCR rate of 1.65% as at 26th Sept. Overall, we are seeing a flat yield curve (the market spread on interest rates is small – 1.30% over 5 years per ASB special rates 3rd Sept).

What are the current inflationary drivers in the economy and what could we see that changes this?

Here’s the conventional economic view:

Wage inflation

There is currently some significant wage inflation in New Zealand. You don’t need to look beyond the 6 o’clock news for this with teacher strikes, nurse strikes and minimum wage increases.

These lifts in wages may prompt other wage hikes as people try to maintain their income differential.

Wage inflation leads to further ‘discretionary’ income available for people to spend and as we know more spending equals higher inflation. That said, most of the wage growth is at the lower end of the market where spend goes into deferred essentials.

It will also lead to further costs for businesses (a higher wage bill) which should increase the cost of the goods they sell to offset this.

Fuel tax

The most recent increase in the fuel tax will directly impact on the cost of products for businesses. Fuel is a key component to the underlying cost of goods, whether it’s used in production or shipping. Most businesses will seek to push this increased expense back onto the consumer through a higher cost of products and services.

House prices

There remains a large demand in the construction sector, underpinned by public projects (schools, hospitals etc.) which is maintaining construction costs (materials and wages). This, along with KiwiBuild, will set a floor on house prices (especially new builds).

Despite this though, there is a softening in national house prices (particularly Auckland) as lending restrictions begin to take hold and capital gains slow/cease. This could see funds spent or invested elsewhere which will bolster inflationary pressures.

NZ dollar

The NZ dollar has been falling against other currencies (most notably the US – it has fallen from a peak of c74c in April 18 to c66c today). This will result in the cost of imported goods increasing and exported goods (e.g, milk powder) decreasing for the overseas buyer.

The increase in cost of goods will naturally flow through to prices.

The decrease in cost of exports may see a demand of NZ goods increase overseas (as they become cheaper for foreigners). This leads to more cash flow for exporters and therefore more discretionary income.

And here is the unconventional view:

One of the challenges chief Squirrel JB talks about is technology led deflation. In some ways this is reflected in a business’s inability to pass on cost increases. Can businesses increase their prices? At what point do consumers change their behaviour, and say, purchase goods using Amazon?

The internet has made consumers more price aware and retail has never been as competitive as it is now. Many businesses are trapped in industries driven by “lowest cost strategies”, especially those exposed to technology. Wage pressure will simply accelerate investment in productivity and automation. Look at Air NZ’s domestic check-in. You now check yourself in and scan your own bags. Equally, technology is making planes lighter and cheaper to fly. At Countdown you check-out your own groceries. More and more businesses are pushing the process back to consumers. Restaurant kitchens are diversifying into Uber Eats – more business across a fixed cost base. Then we have driverless cars and cloud-based global technology. What about businesses diverting low-value activities offshore like accounting, call centres, processing and administration, and technology development at a third of the cost of doing it domestically. (To watch JB discussing this in depth, jump over here).

Arguably that’s why, in an economy of full employment, we still don’t see widespread wage inflation.

We also have a mountain of debt that needs to be repaid. To put that in context, households alone owe $250 billion in mortgages. A small increase in interest rates very quickly chews up any discretionary income and with tighter credit policy and weaker house prices the house is less likely to be an ATM.

A big chunk of our economic growth has been fuelled by debt growth (borrow and spend) rather than genuine growth, so when the world puts the breaks on debt growth that will naturally have a big impact on discretionary spending as well.

So where does that leave us?

Whether or not we see much in the way of inflation going forward, JB’s view and my view would be that the medium term outlook is for some inflation to emerge. Enough to take rates off their current lows. Economists have given up forecasting inflation and are constantly pushing out their expectations.

There is also a global trend, led by the US, of increased interest rates. The US has lifted interest rates seven times since December 2015 and will continue to do so until they reach 3%+. History has shown in the US that their OCR equivalent needs to be cut 3% on average to spur the economy out of a recession – their OCR equivalent is currently at 2%. 

This in itself has an effect on the NZ economy, which will be addressed in another article, however together with the inflationary pressures coming through the economy may lead to an increase in the OCR. It may also lead to an upward lift in the forward yield curve.

What does all of this mean? In 12 months’ time I would expect the yield curve to be trending upwards, which means that the forward interest rates will be higher. It will not be easy to be in the market and renegotiate interest rates in that environment.

Whilst 12 months rates are attractive at the moment, what you are left with in 12 months may not be so attractive.

For the time being, perhaps look at splitting your portfolio over different periods giving yourself some protection by fixing out for a longer term.

If you'd like to discuss your portfolio with a property investing expert, we'd be happy to have a chat.

Speak to one of our mortgage brokers Hamilton to find out more about mortgage interest rates. You can also use our mortgage calculators to estimate how much you can borrow for a house and what your repayments would be.


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