Brother in law's guide: Opt for variable mortgages rather than 1 or 2 year fixed rates

Here;s the short version. I see a deep global economic recession in 2009 convincing the Reserve Bank to cut the OCR to 1.5% by mid-2009, meaning it's now sensible for home owners to roll their fixed rate mortgages over to either floating rate mortgages or 6 month mortgages to wait for rates to fall further. The one year rates offered right now look tempting at around 5.7%, but will lock borrowers in to a rate that will seem high in 6 months time. Variable mortgage rates will probably drop below 5% by early June, while fixed rates stay at or above 5%.

Now that the Reserve Bank has cut the Official Cash Rate to a record low of 3.5% and has indicated it has plenty of room to cut further, it’s worth looking at whether mortgage borrowers who are rolling over in the next couple of months should float or fix, and if they fix, for what period.

This is actually quite a complex question. It requires a view on where the Official Cash Rate (OCR) is heading, what is happening to wholesale interest rates and what profit margins the banks may choose to impose on top of these wholesale rates. Essentially, it requires a view on the likely state of the global and New Zealand economies, along with an idea of the stability and profitability of the banking system.

Individuals will also have their own situations to consider. If a lump sum is expected in the near future such as a bonus, redundancy payment or inheritance it can make sense to go variable rather than fixed, even if the rate is higher because debt can be paid down early to save money.

Or it may make sense to fix even though the cost is higher because a borrower wants certainty about their outgoings. Everyone’s situation is different. This analysis is aimed at a ‘typical’ mortgage borrower who wants to find the lowest mortgage servicing costs for the forseeable future. I fit into that category, having a sizeable mortgage over the house I live in, so this counts as an analysis aimed at myself and for my brothers-in-law. So I’ll call it the brother-in-law’s guide.

Now the caveats are out of the way, let’s start.

OCR to trough at 1.5%

Firstly, let’s look at where the Official Cash Rate will go over the coming 6 to 12 months, which is about as far out as anyone can sensibly forecast. I think a 1.5% OCR is now likely by the middle of this year, which would see variable mortgage rates drop to under 5% by the 4th OCR announcement of the year on June 11. Most economists are now saying the OCR will bottom out at around 2%.

I’m a bit more pessimistic and I got a strong sense from today’s press conference with Alan Bollard that’s he’s willing and feels he’s able to cut very aggressively to get the economy back on track. The governor has rate cutting in his bones. His first act as governor was to cut rates.

He said twice today he had significant ammunition in the locker to use if needed. He was referring to the OCR and to the Reserve Bank’s Term Auction Facility to lend to the banks if they are unable to roll over their foreign debts.

Also the news overnight (and most nights) from global markets and economies is just awful. Last night the IMF slashed its global growth forecast to just 0.5% and increased its credit losses forecast to US$2.2 trln. This will further hit the commodity prices we depend on and dry up demand for our other exports. Auckland International Airport is going to be a much quieter place over the next year or two.

The other reason I think the Reserve Bank governor will choose to lean even heavier on the monetary policy lever is that the government doesn’t have as much flexibility as many people think to crank up the fiscal stimulus lever much more.

New Zealand is on notice from Standard and Poor’s about a potential downgrade in its AA+ sovereign credit rating unless the government can get its forecasts of rising debt back under control. Alan Bollard may have to take up more of the load than Bill English.

Variable to fall further than fixed

Secondly, we are seeing the last gasp of New Zealanders’ love affair with fixed rate mortgages, particularly the longer term two, three and five year versions. One reason is the obvious attraction of variable or short term mortgages when rates are falling. After all, why lock yourself into high rates in a falling market.

But there’s another powerful force at work. One of the reasons we fell in love with fixed rate mortgages is that our banks were able to get relatively cheap funding for them from very liquid international markets awash with money from the investment banking-led credit boom post 2002/03. Our banks would borrow for terms of one or two years for not much more than it cost them to borrow off each other on local markets. Now the Credit Crunch has destroyed the market for cheap, longer term funding on international wholesale markets and our banks are having to rely on relatively expensive local retail and corporate savers, or ruinously expensive international funding (if they can get their hands on it).

The Reserve Bank is also pushing the banks to lengthen their funding maturities and borrow less offshore to reduce our vulnerability to the sort of financial market shocks we’ve seen in the last 18 months. The net result of these trends is that banks will not be able to offer vastly cheaper fixed rates than variable rates, now that variable rates are dropping like a stone.

Bank profits are under pressure too. The profit margins they charge between wholesale rates and their fixed mortgage rates will, if anything, rise further. This will act to keep the pressure on longer term fixed rates to be higher than shorter term fixed and even variable rates.

We finally may be able to get a positive yield curve. This sounds like something only interest rate anoraks like me should care about. But it is actually a return to a much healthier set of credit markets and sharpens the power of the Reserve Bank’s monetary policy immensely.

Alan Bollard was particularly chuffed today to point out that the average maturity for mortgages had dropped to less than 14 months from over 22 months in the last year. Bollard is helping to sharpen his axe by cutting rates so far and so fast that it encourages borrowers to move to variable rates. He could almost be accused of having an ulterior motive, and who would blame him for it.

Flexibility the key

The final reason for choosing variable or short term fixed rather than long term is that it gives borrowers the flexibility to fix when they see that rates have bottomed out. Being on a variable rate means a borrower can fix at the very moment it becomes clear to people that rates are about to start rebounding. My pick at this stage is that the OCR will have to be put up again in late 2009 or early 2010 as the enormously stimulative effects of these low interest rates, a low New Zealand dollar and the government’s fiscal stimulus of 3% of GDP fire up the economy.

Central banks around the world are also pumping cash into their systems and in some cases just plain printing money to revive their economies. At some stage all this fuel is going to catch fire and interest rates will take off again globally as central banks try to take away the punchbowl just as the party is getting started.

To find out what all the banks are offering, check out our mortgage rates table, which is the most comprehensive, accurate and up-to-date around.

A final note. I think this is what the RBNZ will do with OCR. This is different to what I think it should do. I think it should keep the OCR high because we have a national savings problem that can only be fixed with less spending and more saving. Cutting interest rates encourages exactly the opposite. We also have a domestic inflation problem which will not be fixed with record low interest rates.

A final caveat. If there is a complete meltdown on international credit markets, which cannot be ruled out most nights at the moment, then there is a risk the credit market vigilantes that killed Iceland will pick on other current account deficit culprits like New Zealand, Spain, Ireland and Britain. We could see the warnings about our credit rating turn into a full scale rout of the New Zealand dollar and a complete freeze on foreign credit. That could potentially force the Reserve Bank to put rates back up to defend the New Zealand dollar. That’s what happened in Iceland. That is one risk that could blow my 1.5% OCR forecast out of the water.

This article has kindly been republished courtesy of interest.co.nz. To view this article and other news updates from interest.co.nz click here.

Posted: 30 Jan 2009