The key theme in financial markets up until just over a week ago was central banks regaining credibility, inflation rates therefore predicted to fall quite rapidly through 2023, and central banks being able to start cutting their cash rates again before the end of that year.
But the past 1-2 weeks has brought quite a pullback in confidence about inflation and monetary policy.
This is not because the economic outlook has suddenly improved. In fact indicators have worsened and forecasts for growth around the world have been cut slightly further. Instead, some inflation measures have surprised on the upside in the UK and Europe. But most importantly, officials with the Federal Reserve in the United States have been stating that the markets may well have got ahead of themselves.
The Fed. in fact is signalling that rate cuts before the end of 2023 are not likely at all. As a result we have seen wholesale funding costs for banks lending at fixed rates in New Zealand rise by about 0.3% - 0.5% over the past couple of weeks.
These borrowing cost increases have newly shrunk already tight margins facing banks and suggest that for the very near future extra cuts in fixed mortgage rates to follow the 0.2% - 0.4% cuts from mid-June are not likely. What about increases?
Competition between banks for mortgage business is very strong and much of that competition has focussed on high cashback offers. But these can be expensive to banks in the short-term when bonuses are calculated and a reversion to discounted fixed lending rates appears to already be underway – focussed on the one year term.
Given the difference between the one year fixed mortgage rates on offer and those for longer terms it is understandable that most borrowers are favourably looking at refixing at the one year term with reasonable interest still remaining for two years.
It is hard for me to argue much in favour of fixing longer, but for those who want to, here is something to consider.
On average in the 1990s the usually popular one year fixed rate in New Zealand averaged 8.5%. In the 2000s it averaged 7.5%. In the 2010s it averaged 5%. Since the start of 2020 the average has been 3.0%. With the rate commonly near 4.95% at the moment and monetary policy tighter than average according to the Reserve Bank, where might one expect the average to be over the coming 5-10 years?
Not 3% because the pandemic period was special with our Reserve Bank keeping interest rates too low for too long. Not 8.5% because back then the household debt to income ratio averaged 80% compared with 170% now. People are far more affected by interest rate shifts now than before.
Not 7% as in the 2000s because the debt to income ratio then averaged 150% and people have also become accustomed to a far lower level of mortgage rates on average. The level at which rates are considered to be high is now much lower than before.
What about the 5% average of the 2010s? Arguing in favour of this being too low is the fact that between 2012 and 2019 – most of this period – inflation was much too low at an average 1.2% a year and our central bank had to keep cutting interest rates to try and stimulate more growth and inflation.
But arguing in favour of 5% being too high an average is apparent bank willingness to tolerate lower fixed rate lending margins than in the past.
We are left with at least two things making it impossible to strongly take a position on where the one year fixed mortgage rate will sit on average for the coming decade. We cannot predict changes in bank lending margins (currently 0.8% below average for one year lending), and we can only guess as to how much more sensitive people generally are to interest rates now than in the past.
My best guess is that the one year fixed mortgage rate over the next 5-10 years will average somewhere just above 4%, maybe up to 4.5%.
Meaning what? Once longer term fixed rates get back again close to 4% I can see myself suggesting people shift towards fixing long rather than short.
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