Borrowing costs to banks unusually high at the moment

Borrowing costs to banks unusually high at the moment

Two hands exchanging playing cards

One of the more interesting things in the wholesale money markets at the moment is that swap rates have risen so far they imply an expectation of the Reserve Bank taking the official cash rate to 4%. That is 1% more than I think the cash rate will go.

What is a swap rate?

A swap rate is basically the borrowing cost to a bank at a fixed rate for a set term. Banks do such borrowing all the time because when they lend to a customer at a fixed mortgage rate for two years say, they will borrow at a two year fixed rate themselves in the swaps market and lock in the margin.

Banks in New Zealand do not “ride the curve” as happens in the United States.

This refers to the normal situation there where banks fund their 30-year fixed rate mortgages with floating rate borrowing. Doing so in New Zealand has been very dangerous in the past because of the sometimes high volatility in floating rate borrowing costs.

So, swap rates matter to banks and they matter to borrowers looking to lock in a fixed rate for their mortgage. The swap rates currently are unusually high and that is largely because the large offshore institutions which have traditionally been willing to lend to NZ banks at fixed rates (in the swaps market) are not there in the same magnitude as before.

They are focussing their attention on other markets and grappling with pricing changes related to developments in China, Ukraine, US monetary policy and so on.

What does this mean for New Zealand banks borrowing from overseas?

This lack of offshore interest means that when NZ banks have looked to borrow fixed to lend fixed they have struggled to find a party to deal with. The result has been extra increases in swap rates beyond what would otherwise be the case. That means that blindly reading the swap rates curve as a guide to where traders expect the Reserve Bank to take short-term rates is not a good idea at the moment.

But it also means fixed mortgage rates are unusually high early in this monetary policy cycle.

That is actually quite useful from an inflation fighting point of view and is probably one of the reasons why my monthly Spending Plans Survey early this year showed a solid deterioration in consumer willingness to spend.

My latest survey – yet to be published – shows a further deterioration. The soaring cost of living will be a factor, alongside uncertainty surrounding events offshore and falling house prices. This is very positive (not for retailers) in that it means the Reserve Bank is already seeing the crunch in household spending it traditionally seeks in order to slow the pace of economic growth and eventually suppress inflationary pressures.

This is why I am sticking with my 3% peak for the official cash rate.

That is also why, when taken in conjunction with the unusual situation in the swaps market which should eventually pass, I expect rises in fixed mortgage rates from current levels to be relatively limited. Maybe the 3-5 year rates go up another 0.5%, the 1-2 year rates maybe 1%.

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How does this impact me?