Fall's in the OCR mean falls in Mortgage Rates - Yeah Right!

Recently we saw the Reserve Bank of NZ drop the Official Cash Rate by 0.5% to 7.5%.  This is only the second interest rate cut in five years and market watchers were caught off guard by the size of the cut. They were expecting a more “normal move” of 0.25% in the Official Cash Rate.

Reserve Bank Governor Alan Bollard said: “The New Zealand economy is experiencing a marked slowdown, led primarily by the household sector”.  He noted the deterioration in the outlook for the global economy and the pressures the business sector is facing with rising costs and falling sales.  He acknowledged that economic activity should pick up later this year due to tax cuts, increased government spending, and rising farm incomes. At the same time the Reserve Bank is expecting a prolonged period of household sector adjustment and below average economic growth.  Dr Cullen on the other hand stated he was “very confident” the economy would pick up later this year and that probably the country was over the worst. Of course the election date had just been announced.

While it is nice to have lower interest rates, they will not benefit all borrowers. Those with floating interest rates may have already seen their rates come down. This will especially benefit businesses who often rely on bank overdraft facilities to support their cash flow needs. Those with mortgages, despite further interest rate cuts to come, face an average interest rate in two years time not much lower to what they have today based on Reserve Bank forecasts.  If a mortgage was fixed two to three years ago and maturing now then the rate would have increased from 8% to 8.5% today.  This is because a large percentage of money that banks lend out is sourced from overseas. With the ongoing global credit crisis the margin that the banks must pay has increased considerably over what they were paying say eighteen months ago.

Despite their borrowing costs having fallen over the past few weeks, banks seem reluctant to pass these falls fully onto those seeking mortgage finance. Instead they are increasing their margins in order to cope with rising mortgage defaults.

Around 87% of all mortgages are for a fixed term and the overall average effective mortgage rate at the moment is 8.8%, increasing to 9.0% in 2009, and finally down to 8.7% in July 2010.  Effectively the Reserve Banks ½% cut and the future expected cuts are about stopping the effective mortgage rates from rising, let alone making it fall.

We need to remember that the interest rate cuts are about short term interest rates, and do not necessarily carry through to the longer term two to three year interest rates. These are more a function of what is happening in the United States plus a margin for the perceived risk for New Zealand’s small economy.
 
For investors with money sitting in the bank at call, or in short term deposits, the decline in short term interest rates will mean somewhat lower returns. It is expected that the 90 day bank bill will drop to 6.9% by 2011 from 8.6% in 2008, an income decline of almost 20%.  Depositors can either accept falling rates or try to find some attractive alternatives. Yields on good quality bonds have fallen. Yields on selected New Zealand shares and listed property companies are looking attractive, but there may be further capital losses if the fall in the New Zealand dollar following the OCR cut continues. This may trigger even more of an exodus from the New Zealand capital markets by overseas investors.

For the next few weeks, we will not have any political certainty. Spending announcements by the political parties will no doubt make Dr Bollard grimace when his officials model the costs and the likely impact on the economy. It is a difficult time for the Governor. He needs to remain apolitical, so may be unwilling to make a further cut just before the election when the Reserve Bank’s next policy announcement is scheduled, yet he has to do what is in the best interests of the New Zealand economy.