Will interest rates increase in 2020, or will they fall further?
In order to truly understand what influences interest rates, or the cost of currency, we need to dig around a little bit into a few factors. Forgive the technical jargon, but I’ll try to break it down as much as possible here.
1 – It’s all about the US.
Quantitative easing in the US, or money printing, has caused a higher supply of currency worldwide. Assuming demand is constant for currency, if supply increases, it follows that the price will decrease. The FED (or the US version of the OCR) causes, indirectly, other central banks all over the world, including the Reserve Bank of NZ, to lower benchmark interest rates (in our case, the OCR, or official cash rate). To learn more about how this works, check out this interview with an economist I did in September. The OCR affects short term fixed interest rates, specifically the 1 yr rate.
In addition to the impacts that supply has on the price of a currency, the price of a currency can also be directly manipulated by a central bank. At the risk of being overly simplistic, if the US Fed increases the benchmark rate in the US, our longer-term fixed rates may increase – even if the tone indicates an eventual decrease of the FED, then expect longer-term fixed rates to decline in NZ. Currently, the longer you fix your mortgage for, the more expensive the rate is – the reason they’re more expensive, is due to ‘term premium’, or the extra price you need to pay for certainty around your mortgage payments. Bringing back the supply-side dynamics, if the money printing slows down or even reverses, ie. if there is quantitative tightening, this could cause longer-term fixed rates to increase. At this stage, it appears as though we are heading down infinite QE.
2 – Markets are cyclical.
We’ve exited the classic short-term debt/business cycle, and typically rates would fall from here. Where can they go when they are already at record lows? The intervention from the central banks post GFC (Global Financial Crisis) has had side effects – distortions specifically. It’s hard to use traditional indicators to predict outcomes when there is outside manipulation from regulators occurring at such a great pace. We have no way of knowing for sure, for example, what the impact of the next change in the cycle will bring. At this stage, it appears that the low point in this interest rate cycle is now acting as a high point in the next cycle. Historically the catalyst to send us into the next period has been external (The Global Financial Crisis in 2008 was the last great catalyst). It’s currently unclear what the next catalyst is, but most are speculating it’s in the form of an overvalued share market and property market.
The property market has slowed a bit in 2019 in volume and average sale (more or less), possibly in anticipation of a macro-slowdown that did not eventuate. The sentiment is improving now and 2020 could be the beginning of a new cycle of optimism (then again, it could be a seasonable blip – time will tell).
3 – Regulation.
Regulators, like helicopter parents, are hell-bent on ensuring a recession does not happen. This comes from a good place, but it has unintended consequences. Economic slowdowns/recessions are actually necessary from time to time in any healthy and growing economy and often in attempts to avoid them, regulators are kicking a bigger can further down the road.
a – Tax may increase: This may not just in the form of direct income taxation but indirect ways also (fuel to name but one). This generally slows down the economic outlook and puts further pressure on our OCR to decrease. Our dollar may fall as a result, which in turn, increases revenue for exporters.
b- LVR regulations: This ‘indirect’ macro-prudential tool can be adjusted, which changes the flow of lending to different parties purchasing property. The Loan to Valuation Ratio restrictions have been helpful in controlling the property market without using the lever of interest rates during the last ‘booming’ period of 2014-2018. If property demand increases from here too much though, this puts upward pressure on interest rates unless further non-conventional tools (like ‘debt-to-income ratios) are implemented.
c – Capital reserve requirements: The quiet battle going on between the main banks, and the reserve bank has just come to a conclusion. To increase financial stability, the RBNZ was keen to ensure that banks hold aside a higher buffer to ease the impact of future significant (one in 200-year events) chance of something going wrong. The impact of what the RBNZ did is twofold: The regulator has gained some respect and, interest rates could increase (as banks pass this cost on to borrowers). As the changes will be implemented gradually though, this could slightly offset the rate at which interest rates march on towards zero.
d- Lowering of the OCR: Many have played the game of crystal ball gazing this year around what the OCR was going to do, and they got it wrong – myself included. I would suggest next year will be a ‘long flat’. Not much change to occur, if any, with respect to OCR adjustments. This is largely due to the uptick in property market sentiment – lowering the OCR may add fuel to a smouldering property market and kick it into life again.
e – Deflation/Inflation. No one’s talking about this yet, but there’s a strong chance NZ is going through deflation, as I suspect other major economies are too – If this theory is true, it’s extremely dangerous given the levers that can be pulled, have already been put on the lowest historical setting (OCR). Deflation defers expenditure and encourages hoarding and investing in non-productive assets further, like real estate. The consumer price index (CPI) does not measure the impact of falling interest rates on the ‘basket of goods’ – interesting, considering this is the most significant expense of the middle class. The real concern with deflation in an environment where there’s worldwide quantitative easing is that it could flick over to inflation very quickly.
So, how long should I fix my mortgage rate?
A 1% increase on $1m mortgage works out to an increase monthly payment of almost $850pm – could you afford this? Even though this appears to be an improbable event to guard against, rising interest rates could still happen – if they did happen, ironically it would be the regulator (who’s trying to keep us safe remember), who will be to blame.
Still, it would make sense to enjoy the low-interest rates currently on offer, right? This is currently the 1 year fixed rate. In order to avoid getting hooked on the ‘crack of low-interest rates’, a wise move would be to ‘condition your cash-flow’.
A good example of conditioning your cash-flow is to pay off your mortgage assuming a higher rate applies. Simply work out what your payments would be on a higher interest rate, but instead of actually choosing the higher rate, simply increase the amount you pay off your mortgage (trade the interest rates savings for extra principal reductions).
Another way to condition your cash-flow is to spend an amount equal to the savings into a separate investment (KiwiSaver is great for this as you can’t take it back out).
By conditioning your cash-flow you will help absorb a shock in the future, should the unlikely event of higher interest rates take place.