Shifting interest rate risks

Child playing jenga

Welcome to 2021 and another year when in all probability house prices will continue to rise at a strong pace, with a key driving factor continuing to be record low interest rates.

In fact, the year has started with one major bank cutting its one-year fixed mortgage rate down to 2.29% from 2.49% and others will likely follow. They’ll probably replicate the cut because almost everyone continues to fix for just the one-year period.

For some, this decision will reflect an expectation that interest rates will remain low for a very long time, therefore rolling over from one low one-year rate to another each year for the next few years could be the optimal thing to do.

But for most, the decision to lock in a rate for just one year will be driven by a desire simply to enjoy the lowest borrowing cost possible right now.

Is this a wise strategy?

On average over the past ten years the one-year fixed mortgage rate has averaged 4.8%. The two-year rate has averaged 4.9%, three-year 5.2%, and five-year 5.9%. Rolling over a one-year rate would have been a very good strategy for the past decade.

But this past decade of post-GFC years has been unique because of the downward surprises on inflation rates here and overseas. Because of a wide range of factors such as excess capacity, deunionisation, reduced business price-setting ability, and offshore competition, the relationship between economic growth and inflation has changed.

For any given pace of growth, post-GFC inflation has turned out to be lower than before 2008. But we now know this, and the chances are not high that we will see a further reduction in the strength of this relationship. Instead, inflation risks, once we get beyond the depressing effects of still-spreading Covid-19 overseas, are turning upward.

Hefty money printing and government plans for more fiscal stimulus run the risk of igniting higher inflation. We cannot possibly know by how much, where, and when. But we can be reasonably confident that the old low inflation and low interest rate surprises have about run their course.

That is why people should perhaps exercise slightly more caution regarding locking in a fixed rate for just one year now, compared with what has been a successful strategy of doing so since 2009.

Is it worth fixing three years at the common rate of 2.65%?

At a pinch, rolling over a one-year rate may produce a slightly lower borrowing cost. But if we stretch out to managing a mortgage over at least the next five years, then locking in some portion of one’s mortgage debt at a five-year rate of 2.99% may be a wise thing to do.

Nothing specific suggests that our central bank will be raising interest rates in the near future, though the case can be made that they went too far over 2019 and 2020 with their interest rate cuts, given what they have initiated in the housing markets around New Zealand.

But, as this year progresses, as people contemplate extra government spending in the United States and elsewhere, and as money printing continues, there is likely to be upward pressure on medium- to long-term interest rates. Movements upward may not be great. But for those people who have been holding off fixing five years because they want to maximise enjoyment of low short-term rates as long as possible, the risks of missing out on locking in a record low long-term rate are rising.

After all, the most globally-watched long-term interest rate, the ten-year US government bond yield, has already risen from a low of 0.5% in August to 0.9% in December and 1.1% now.

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