A global interest rate shock is underway

A global interest rate shock is underway

Zoomed out shot of a city, lightning strike

As a result of annual inflation rates surprising on the high side overseas, recent renewed increases in energy prices, and rising food prices because of Russia’s blockade of Ukrainian ports, central banks have all but pressed the panic button. The chances are now over 50% that the world economy will soon slip into recession with assistance by central banks rapidly raising interest rates to ensure inflation rates start coming down fairly soon.

Were it just the shocks from food and energy prices causing higher inflation – transitory factors – then central banks would have time on their side. Last year they thought they did and repeatedly said that rates would not rise until 2024.

But central banks around the world over-corrected the situation

It has been clear to many of us since early-2021 that central banks, including our own, had over-stimulated their economies. They should have pulled back on printing money and started raising interest rates over a year ago.

But by continuing to focus on boosting growth and employment they have forced their economies to grow beyond the capacity of their resources to keep up and inflation has become embedded. In New Zealand our own Reserve Bank has admitted that the unemployment rate is unsustainably low. They need it to rise otherwise wages growth will lead to price increases which will risk inflation staying above 3%.

So, just as the Reserve Bank recently raised its cash rate by a strong 0.5%, so too are other central banks doing that or signalling they probably will. In the United States in particular the anticipation of exceedingly rapid interest rate rises for the rest of this year has caused share prices to fall away sharply.

In New Zealand what all this means is that the interest rates at which banks borrow to lend at fixed rates to homeowners have risen substantially. The one year swap rate for instance which forms the base from which banks calculate their one year fixed mortgage rate has risen to about 4.1% from 3.6% two weeks ago and 3.2% in the middle of May.

How do high swap rates affect mortgage interest rates?

Such a rate means that with many banks still charging about 4.5% for one year fixed rate specials, margins have shrunk to unsustainably low levels. In fact the one year fixed rate margin is about 1.4% below its average for the past two years.

There are some big mortgage rate rises coming along very soon with the greatest increases to be for the one year rate with lesser increases for the other terms.

As things stand the financial markets in New Zealand are factoring in an expectation that the Reserve Bank’s official cash rate will rise to 4.5%. That is above the 3.9% peak picked by the Reserve Bank for the middle of 2023 and above also the 3.5% peak most of us economists have in our forecasts.

This suggests that banks may exercise caution with regard to how far they raise their rates in the near future because their economists will be telling them that the markets may have become too bearish. As the outlook for economic growth around the world and in individual economies worsens, we will potentially quickly reach a point where the mortgage curve is inverse and long rates in fact fall down.

The speed with which central banks are catching up on their delayed tightening and the anticipation of economic damage which will result in the coming 18 months means that the bulk of the rises in our mortgage rates are likely to be done before the end of this year.

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