Tony Alexander Update Oct 22

Interest rate alterations

 

The situation with regard to mortgage interest rates in New Zealand has changed somewhat over the past few weeks. Up until very early August the prevailing mood around the world was one of optimism with regard to inflation being brought under control. Markets expected that their central banks would keep raising official interest rates for the rest of this year through well into 2023. But then there was an expectation that those interest rates would start to be cut.

It turns out that the optimism was somewhat misplaced. It's not so much that releases of monthly inflation numbers have been higher than expected but more the case that data on the strength of labour markets have been considerably firmer than anticipated.

This is important because a key mechanism whereby inflation is brought down is a loosening of the labour market as businesses pull back on their hiring intentions. So far there is not much indication of that happening because businesses are short of staff and scared that if they should lay people off, they won't be able to hire them again.

These concerns have led central bankers to issue fresh warnings about the speed with which they will need to raise interest rates, the heights which interest rates might need to go to, and the period of time over which they will need to stay at high levels. Their concerns have been factored into wholesale interest rates.

Now there is an extra factor which has had a substantial impact in the markets. In the United Kingdom the new Prime Minister and Chancellor of the Exchequer have undertaken an irresponsible easing of fiscal policy at the same time as the Bank of England is trying to fight inflation by raising interest rates. Easier fiscal policy will boost demand for resources in the United Kingdom which are already in short supply. The outcome will be extra inflationary pressures against which the Bank of England will have to lean by raising interest rates further than previously anticipated.

This has caused a sell off in UK government bonds with extra selling caused by the anticipated blow out in the budget deficit. And on top of that there has been extra selling because of comments from the Bank of England indicating initially they had no intention of doing anything about the altered situation. They have now promised to buy government bonds to suppress the heights to which yields will go but there is also pressure on them to initiate an extra immediate increase in interest rates.

The situation is very fluid and the outcome for now is that wholesale borrowing costs facing New Zealand banks have gone up. Because margins on fixed rate lending in New Zealand have fallen to exceptionally low levels banks have had no choice other than to boost their fixed lending rates. But even after these increases margins are still well below average for the past two years, so we cannot rule out further increases occurring.

But we also cannot rule out a lot of the recent turbulence in the markets calming down very quickly. History shows that financial markets have a tendency to overshoot whether we be talking about interest rates or exchange rates or commodity prices. Therefore, borrowers may want to wait awhileto see where things settle down before unnecessarily altering the popular borrowing strategy recently which has been to fix for periods of either one year or two years.

One important thing to keep in mind is that the stronger central banks attack inflation now the greater will be the pace with which inflation falls away down the track and the faster will be the falls in interest rates when they occur.

That means I'm sticking with my view that while interest rates won't necessarily change much over the next 12 months there is good scope for falls from late next year. That doesn't mean one should only fix one’s interest rate for one year because these are still extremely uncertain times. A borrower should not turn their nose up at potentially locking some of their debt in at a fixed rate for two or even three years given that none of us know what is going to happen in Ukraine, or with oil prices, or especially with labour markets and wage pressures.

By Tony Alexander

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