Fixed rate hikes reflect market expectations

Fixed rate hikes reflect market expectations

Street with lit up signs

Mortgage interest rates have now risen by between 1.3% and 1.8% from where they were less than six months ago as banks have reacted to sharp increases in their cost of funds. How can this be, many people must be wondering, when the Reserve Bank has increased the official cash rate by only 0.25% on October 6?

Changes in the cash rate – OCR – have their greatest impact on the cost to banks of borrowing money for floating interest rates. Those lending rates so far have barely budged. The one-year fixed mortgage rate for most lenders has however risen from 2.19% to almost 3.5%. This reflects a rise in the cost to a bank of borrowing money at a fixed rate to lend fixed for one year, from about 0.7% to 2.3%.

That 2.3% borrowing cost reflects not where the OCR sits right now, but where traders in the money markets expect it to sit over the coming year. Expectations are high that to get inflation back down from the current 4.9% and to push back against rising inflation expectations, the Reserve Bank will need to raise the OCR to perhaps 3%.

Why don’t banks just finance their fixed rate lending with floating rate borrowing?

Because that is extremely dangerous in New Zealand where interest rates have a near four-decade history of high volatility. If a bank lends fixed and borrows floating believing that floating rates stay low, they may end up locking in large losses if floating rates suddenly surge.

This happened to one large bank in 1995 and it cost them around $100 million. In New Zealand if you lend fixed you borrow fixed.

How high might fixed interest rates go?

I have previously given a view that the likes of the previously very popular one-year rate would rise just above 5%. That was before learning that the unemployment rate had fallen to a record low of 3.4%, that supply chain problems around the world are expected now to persist through to 2023, and that inflation had jumped to 4.9%.

Now, a rate close to 6% is quite possible

When that happens, fixed interest rates for periods three years and beyond are likely to be lower than the one-year rate. Contrast that with the current situation where the five-year rate for instance is commonly just below 5% and the one-year rate near 3.5%. We call that a positively sloped yield curve.

In every monetary policy cycle a point is reached where people expect high interest rates to crunch inflation lower by curbing economic activity. When that happens expectations shift from anticipating a higher official cash rate to expecting that it will be cut. Those expectations lead to declines in longer term fixed mortgage rates. The result is an inverse yield curve.

Back in 1998 for instance the yield curve was inverse with the one-year fixed mortgage rate hitting 10% at the same time as the five year rate was 9.4%. The impact of very high interest rates was so strong, within just over six months the one-year rate had fallen to 6.0% and the five year rate to 7.5%. That is when thousands of people tried to break their previously relatively “cheap” five year rates.

In 2008 the one-year rate hit almost 10% again and the five year rate 9.3%. Within 11 months these rates respectively were 5.8% and 6.5%. Again, people learnt anew what a break cost is.

At some point, maybe two years from now best guess, the yield curve will be inverse and some people will lock in fixed for fix years because it will be cheaper than fixing one year. And history tells us some 6-12 months after that happens, interest rates will be much lower.

If you are choosing to keep following the strategy of continually rolling over into one-year fixed rates (the best strategy since 2009), be aware that somewhere down the track your nerve will be tested.

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