The new year of 2023 is upon us and the big concern for people who did not lock their mortgage interest rate in for five years when rates were 3% or thereabouts over 2020-21 is how much higher fixed rates will go as the year progresses.
The commonly accepted view is that rates will rise a lot further with most people ending up locking in at fixed rates from 7% to 8%. For floating rates, a peak near 9% is highly likely because changes in the floating rate a bank charges are closely related to changes in the Reserve Bank’s official cash rate.
The OCR is currently 4.25%
And it looks set to head as high as 5.5% come the first week of April. That means floating mortgage rates will rise another 1.25% or so. But the dynamics regarding bank pricing of fixed rate loans are very different.
How much banks charge in interest depends on how much interest they’re paying to borrow, themselves
When a bank lends, say, two years fixed it borrows at a two year fixed rate in the wholesale market and immediately locks in the margin. This is good risk management practice in a country with a history of sometimes sharp changes in short term bank funding costs.
For a person contemplating lending to a bank at a fixed rate for two years the comparison traditionally made is between the worth of doing that versus lending to the bank at a rate which floats up and down for the two year period. To make the comparison the borrowers need to have a view on what floating wholesale interest rates (closely tied to the OCR) will do over the next two years.
The financial markets expect that the OCR will rise to about 5.5% and not start falling until maybe early-2024. This common (more accurately this average) market view produces a wholesale interest rate which a bank must pay to borrow fixed two years then lend fixed two years of about 5.2% at the moment.
Note that this rate is below the expected peak in the OCR because it captures expectations of the OCR going down.
Now, here is the important point to grasp
This 5.2% cost already reflects expectations of the cash rate going to 5.5%. So, if it does in fact reach that level come April then nothing happens to the two year wholesale bank borrowing rate.
As the cash rate rises further, there will be a little bit more upward movement in one year wholesale borrowing costs, but little if any rise for longer rates. In fact, if things pan out as the market currently expects then these rates will soon be trending lower.
Is there a chance rates will rise higher than expected?
We are only going to see fixed mortgage rates for periods of two years and beyond rise higher than current levels if banks decide to boost their lending profit margins, or we get new worrying news about inflation which causes monetary policy expectations to change. If for instance the new information means the cash rate is expected to peak at 6% and not 5.5%, all fixed rates will go up. If it looks like the Reserve Bank won’t be able to ease monetary policy in 2024, again fixed rates will go up.
So, we all need to keep an eye on economic data in coming months for things like inflation (January 25), plus measures of pressure in the labour market derived from the likes of the ANZ’s monthly Business Outlook Survey and the quarterly Household Labour Force Survey.
What about banks raising their lending margins?
That is unlikely. They currently sit at levels they have averaged for the past two years and the decline in house sales means bankers are failing to meet their loan sales targets. If anything, the bankers will be thinking about cutting fixed rates soon to gain market share rather than raising them.
Things remain very fluid in the interest rates markets in New Zealand and offshore. 2023 is going to be a year of learning about how inflation behaves in a post-pandemic world with Russia going to war against a neighbour. Don’t pay excessive attention to any one set of interest rate forecasts and do fully expect all of our forecasts to change repeatedly as the year progresses.
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