Fixed and floating mortgage rates, and the OCR

Note:  Apologises for the lack of action here.  If I was any busy I would become a singularity.  Regular posting will eventually restart.  Now for a post …

Bernard Hickey recommended sticking to floating mortgages for the long haul on Rates blog recently.  This is in stark contrast to Tony Alexander’s suggestion that, in a few months, fixing will be the way to go.

Now fundamentally, I think these two authors AGREE on the track for the official cash rate going forward.  The difference stems from the expectations for floating and fixed rates.  Personally I agree with Tony.  Why?

Bernards argument, in my opinion, hits a certain flaw right here:

If, for example, the Reserve Bank starts increasing the Official Cash Rate from its 2.5% to around 5% by the end of next year, then variable rates are expected to rise to around 8-8.5%. Given fixed rates are also expected to rise by a similar amount to around 9-9.5% the choice is clear for those simply looking for the cheapest rate.

This isn’t how floating and fixed rates work per see.  The current official cash rate influences interest rates now by providing some opportunity cost in sourcing funds.  The future official cash rate influences fixed interest rates now, by changing the opportunity cost of sourcing funds in the future.  As a result, the fixed rate depends upon expectations of the OCR in the future, while the floating rate only depends on the OCR now.

Given that everyone expects the OCR to lift appreciably in the coming quarters, it makes sense that the current floating rate is below the fixed rates.  However, as the OCR increases floating mortgage rates will lift by a greater amount than fixed rates.

Bernard Hickey is absolutely correct when he says that the world is different, and the make up and structure of interest rates will be different than we have experienced in the past.  However, as we move through the upward swing of the economic cycle I would expect fixed rates to become “relatively cheaper” than floating rates in a static sense.

  • Matt

    What about the extra 130 basis points of funding costs that are now built into the structure of longer term fixed rates for the longer term?

    cheers
    Bernard

  • I still say engage in a bit of personal carry trade: take out your mortgage in Canada.

  • @Bernard Hickey

    Hi Bernard,

    The extra 130 bps is on current wholesale funding. As a result, there is a premium on all maturities, even the floating rates – hence why the gap between floating and the cash rate is at a historic high.

    There is a debate regarding how permanent this increase in funding even is (will it disappear as rates increase – is it a result of the NZ interest rate being implicitly pegged to foreign rates?), and the bank seems happy to assume it is permanent as it looks like it IS priced into current fixed rates.

    However, as the OCR rises, we will see the gap between floating and fixed reverse at some point in the cycle. As the fixed rates are based on a stream of floating rates over time.

    Note: Prudential regulation has fiddled this a bit by forcing banks to match maturities, it will be interesting to see how interest rates now respond to the cash rate. Even so, the yield curve will invert (short rates higher than long rates) the next time our economy is growing strongly.

  • @Eric Crampton

    I would, but I’m not buying a house – no way at current prices 😀

  • swan

    Eric,

    I would consider it but what Canadian bank is going to lend money on my NZ house?

  • I bought in 05; think prices now are slightly above that point. Was less investment decision and more consumption.

  • @Eric Crampton

    Prices are well up on ’05. And it has to be a stream of consumption for sure.

    However, renting definitely suits me at the moment

  • Were I single, I’d have bought something very small on arrival in ’03 but wouldn’t have bought in ’06 or later; I’d definitely not be buying now given high chance of house price drop with depreciation changes on rental properties.

  • @Eric Crampton

    Exactly. I’ll wait till the baby boomers are desperate to sell – I’m sure that sounds immoral, but not to worry.

  • @swan Strategy may depend on having pre-existing access to Canadian collateral.

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  • Kimble

    Baby boomers desperate to sell? When is that likey to be?

  • @Kimble

    In my dreams …

    Either way, the life of an economist is one of soulful reflection, we shouldn’t be materialistic and own property. I’m willing to claim that this is the reason why I haven’t purchased anything.

  • Matt

    But don’t the bank funding costs increase ‘further out’ the curve, given the costs of longer term funding are inevitably more than short term fund (now we have a positive yield curve) and the Reserve Bank is forcing them to avoid funding/maturity mismatches?

    cheers
    Bernard

  • Kimble

    As someone who didnt get onto the housing ladder early on (I thought they were overpriced when I started looking, but they just got even more over priced as time went on) I am eager to hear about any events that could bring the house price down and confirm my earlier decision was the right one.

  • @Bernard Hickey

    At the moment yes. But as the OCR increases, and the future expected OCR is expected to be lower, then the rate of increase in the fixed rates will be slower than floating rates. The reason fixed rates are higher now is because the OCR is expected to be, on average, higher in 1, 2, 3 years times.

    Forcing the banks to match maturities has increased fixed rates as well – no doubt. But over the economic cycle we would still expect the yield curve to invert at some point. What was weird was the fact that the yield curve in NZ was pretty much always inverted, that didn’t make much sense.

  • @Kimble

    Tax treatment is bound to have some impact. Look at how serious suggestions of tax have lead to a collapse in investor demand, and rising listings, in the marketplace. There is going to be pressure on prices – the question is how sticky nominal prices will be …

  • Kimble

    Yes, nominal prices. The government should increase the inflation rate, that will make the mortgages people have now more affordable, and will make the real price of property fall.

    This argument was put to me last week. No joke.

  • @Kimble

    Lol,

    Let me guess, the person had a mortgage right 😀