Why short-term mortgage rates are best

The Reserve Bank has committed (as much as it can) to holding rates low for the foreseeable future and why wouldn't they? We are in a major recession that will hang around for a long while yet. Just consider the downstream impact of the rising unemployment rate and reduced dairy payouts. I'll explore it further later but my view is that the highest one-year housing rate in the next five years will be 8.50% based on the OCR getting to 7%. If 8.50% is the worst we will see rates (my view) then is it all that bad? For example, on a $300,000 mortgage the monthly repayments at 5.50% using a 25-year term are $1,842 per month. At 8.50% using interest-only the repayments are $2,125 per month. So even with rates as high as 8.50%, an extra $300 per month is hardly the end of the world! Long-term rates only look attractive if you buy into mortgage rates shooting back up to 9.50% again. In my mind this won’t happen anytime soon and is irrational fear.

Dig deeper

Ok, time to dig deeper. Start by having a look at the following graph. It shows the official cash rate (OCR) history for New Zealand and Australia. The first obvious point? How long it took rates to peak from when they started rising - four years. The second point is how slowly rates increased in Australia (because 70% of their market is on floating rates.) Historically the Reserve Bank has had to hike interest rates up quicker and further then it would like because Kiwis have been locked into fixed-rate home loans. In Australia, most home owners are on floating so the Reserve Bank of Australia has been able to increase rates more gradually. With long-term rates so high in New Zealand, borrowers are choosing short-term rates. So our housing book is starting to look more like Australia’s. When rates do eventually increase this means the impact will pass through to borrowers more quickly, thereby putting less pressure on further rates increases. In a perverse way, high long-term rates are helping convert more Kiwis to floating or short-term fixed rates.

My geeky side rears its head: future "implied" rates

Five years ago I headed a team which analysed rates, and we found that short-term rates outperform long-term rates 82% of the time. Although that analysis is old I think it still holds true today, especially now with long-term rates so high. That means you are better off taking consecutive short-term rates than a five-year rate. The following graph shows the implied forward housing rates today. If you believe the one-year mortgage rate will track above this level then you are better off in long-term rates. If you believe rates track below this level you are better off in short-term rates. Based on current mortgage rates, the one-year rate needs to get to 10% within three years for the current five-year rate to be considered "good value." I've put my view of what the one-year fixed rate will look like (for comparison) and calculated out the difference in actual cost. What you can see is that if mortgage rates follow my forecast you'll be 1.30% better off choosing a rolling one-year rate rather than the five-year rate. Naturally the cost-benefit equation will depend on your view of future mortgage rates.

Higher funding costs: a red herring

The banks have their highest home loan margins in over 10 years, which is a function of having to pay much more than normal for deposits (robbing Peter to pay Paul.) Ironically, as I have discussed in an earlier blog, Kiwibank is a key driver of the "deposit price war" as it has pushed up retail deposit rates to fund its housing growth. (They didn't talk about that at the Parliament Finance Committee!) High margins are already compensating banks for higher funding costs. When funding pressures eventually come off we will likely see long-term mortgage rates drift down a bit from current levels. Ironically it is currently cheaper to fund offshore than with retail term deposits. This is temporary insanity!

In summary

1. More Kiwis are choosing short-term rates.  This will make the OCR a more effective tool in the future and slow down any rate increases.
2. Implied forward rates suggest that long-term rates are at least 1% overvalued.
3. There is plenty of margin in the system for the banks provided they do not get too silly pricing domestic term deposits.
4. Greater financial regulation and tighter credit rules will keep the brakes on lending growth, which in turn will keep less pressure on interest rates.

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