Bernard Hickey: Seismic shift in the market

Reserve Bank Governor Alan Bollard. Photo / Mark Mitchell

The instinctive reaction of home owners when interest rates start rising is to lock in for a long fixed term.

The prospect of continual increases in a floating mortgage rate as the Reserve Bank of New Zealand progressively raises the Official Cash Rate (OCR) is too much for some to bear. But fixing rather than floating is no longer automatically cheaper.

The Reserve Bank's decision last week to leave the OCR on hold and suggest it will raise interest rates in coming months confirms that something fundamental has changed in the mortgage market and the economy.

During the housing boom from 2002 to 2007 banks were able to offer relatively cheap fixed-rate mortgages because they could dive into the "hot" wholesale money markets and raise money cheaply.

Now these hot markets are less welcoming and the Reserve Bank and the banks realise they need to wean themselves off this source of funding.

The Reserve Bank has formalised this push to get funding from more secure and longer-term sources through its Core Funding Ratio (CFR), which specifies the banks must fund 65 per cent of their lending from secure and long-term sources.

This ratio will rise to 75 per cent within the next two years and will intensify the push by banks to compete for term deposits from mums and dads and issue more expensive longer-term bonds on international debt markets.

This change is pushing up overall funding costs for banks.

This has done two things. It has pushed up longer-term fixed rates and lowered variable rates, called "curve steepening". Since April last year the average two-year fixed mortgage rate has risen from 6.24 per cent to 7.13 per cent, interest.co.nz data shows.

Meanwhile, the average floating rate mortgage has dropped from 6.34 per cent to 5.86 per cent. This is to pay for the average one-year term deposit rate which has risen from 4.39 per cent to 5.05 per cent over the same period.

The question for borrowers is whether this gap will stay and whether it will be big enough to justify floating rather than fixing over the longer term.

So why won't the market go back to the "normal" seen from 2002 to 2007? The answer is the crisis changed all that and the Reserve Bank is ensuring banks won't slip back into their easy, hot funding ways.

bernard.hickey@interest.co.nz