KEY POINTS:
The housing boom has sent household debt levels through the roof and interest rates are becoming a national obsession.
The Reserve Bank's cash rate calls and any other event or data supporting the case for a move in rates are breathlessly presented as signalling either imminent relief or pain for homebuyers.
While that relationship still exists, it has become increasingly muted. Since the credit crunch began last year, the official cash rate (OCR) has stayed at 8.25 per cent but mortgage rates have continued to move around.
New Zealand homebuyers now have an overwhelming preference for fixed-term home loans, which for the majority of the time are cheaper than variable rate mortgages.
This is a frustration for the Reserve Bank and its Governor Alan Bollard as any changes to the official cash rate, to the extent that they are reflected in mortgage rates, only affect households when they come to refinance their mortgage, which is usually every two years. This is the so called "pipeline" effect. Some would argue that given how much more indebted we are, the RBNZ's rate movements are ultimately more effective in influencing the economy, even if they take longer to work.
As the credit crunch rolls on mortgage rates have moved up, which may be ascribed to the pipeline effect, but they have also moved down.
Mortgage rates are clearly not bound by the RBNZ.
The key reason is that given New Zealanders' relatively poor record as savers, most fixed term borrowing is funded via the banks from overseas investors.
The banks, having a fixed rate of interest coming in off their mortgage lending, want a fixed rate going out on their funding. They achieve this via the so-called "cross currency interest rate swaps" market.
Ordinarily it's the rates available to banks on the swaps market plus a small "spread" or additional amount to reflect transaction costs and general market conditions that drives pricing for banks' overseas funding and thus local fixed mortgage rates.
Unfortunately, these are not ordinary times and the spreads have ballooned, but let's look at what drives the swap rates themselves.
BNZ chief economist Tony Alexander says swap rates are still to a large extent driven by the OCR, or more correctly expectations of where the OCR is going.
Mortgage rate increases early this year were to some extent driven by higher rates on the swaps market, in turn resulting from expectations that the RBNZ would again lift the OCR in response to fresh signs of inflation.
This week's Budget has seen economists' expectations of when they expect the RBNZ will begin easing, which had previously been brought forward by a series of soft economic data, pushed out further once again.
The two-year swap rate, which in turn largely drives two-year mortgage rates, yesterday rose to 8.13 per cent, up from 7.7 per cent last week.
Bank economists yesterday said that if the two-year swap rate stays around this level for long, we can expect mortgage rate rises.
Meanwhile, given the "cross currency" nature of the swaps market, interest rates offered in other countries, particularly the US, have an influence as well - although Alexander says this has become less pronounced in recent years.
If that was not the case, the US Federal Reserve's big rate cuts early this year as it sought to free up credit markets would have driven swap rates down considerably. They didn't.
Another factor in the swaps market is simply supply and demand.
"In this environment where buyers have stepped back from the market we naturally get this downward pressure on swap rates," says Alexander.
Another factor that pushed mortgage rates to multi-year highs early this year was increases in the spread over and above swap rates. The spread reflects transaction costs and, more crucially, the current risk climate. The credit crunch saw credit spreads for everybody, no matter how good their credit rating, increase dramatically.
A source at one of the major banks recently told the Business Herald the margin above swap being paid for overseas funds before the credit crunch was somewhere between five and 10 basis points or hundredths of 1 per cent. These days it's about 70 or 80 basis points.
While many are hailing the beginning of the end of the credit crunch, others, including billionaire investor George Soros, warn that while the "acute" phase of the crisis in financial markets might have passed, there are further wider-ranging effects yet to be felt.
BNZ chief executive Cameron Clyne earlier this month said international markets remained fragile and additional shocks could cause them to lock up again.
How likely is that? Enough of a threat that the RBNZ this month put in place facilities which will allow it to extend what amounts to emergency funding for banks if their supply of offshore funds dries up.
Yet another factor that may impact on banks' funding and mortgage rates is the RBNZ's concern that they have been increasingly borrowing on shorter terms during the credit crunch because it has been cheaper to do so. However that has led to a bulge of maturing loans which will need to be refinanced over a relatively short period next year.
That could cause problems if markets have not recovered or if they have deteriorated further by then and may put pressure on banks' ratings, Moody's warned recently.
The RBNZ has acknowledged that should the banks do as they are asked and lengthen the maturity of their loans, their cost of funding will rise and that will inevitably be passed on to customers.
Meanwhile, even if the worst is indeed over, bankers say credit spreads will take months if not years to return to more usual levels. "That's what no one knows," says Alexander.
"Not even [US Federal Reserve chairman] Ben Bernanke knows to what extent the credit crunch is going to ease off over coming months and at what speed. That's something we just take as it comes along. We have seen some easing over the last three weeks in that tightness overseas, but that could go back the other way again relatively easily. We don't know, we take it as it comes. That's why it's not reasonable to forecast where the fixed interest rate goes just on the basis of swap rates alone."
Having said that, Alexander believes that even with a continuation of margins at current levels, the prospect of RBNZ cuts this year, albeit later than previously thought, should see swap market and mortgage rates ease towards year end.
He now expects to see two-year fixed mortgages somewhere between 8 and 8.25 per cent by then.
Auckland University of Technology senior lecturer in economics Susan Schroeder, however, sounds a note of caution.
She believes the RBNZ may be constrained by events in the US where, even more than New Zealand, inflation remains a big problem.
"It's possible that not only have we seen the end of interest rate cuts in the US, but there is a chance that the Fed will begin to increase interest rates in an attempt to put a lid on inflation. The tightening could come as early as September - about the same time that the pundits here are arguing that the RBNZ will start cutting the OCR.
"If the Fed begins to increase interest rates, there may well be downward pressure on the New Zealand dollar and an increase in inflation here, as a weakening kiwi raises the domestic prices of imported consumer and investment goods.
"It's possible, then, that the RBNZ may not move to lower rates but actually increase them in an attempt to get a handle on inflation and protect the confidence that foreign investors hold in this economy."
Alexander says the key question with regard to a rapid fall in the currency is whether it occurs because of the Reserve Bank's stance or not.
If it falls because the market believes the RBNZ will cut rates, then swap rates are likely also to be on the way down. "If it's going down because investors don't like the look of our shaky isles any longer our interest rates go up."
For New Zealand households, sweating from high fuel and food prices, an easing in interest rates looks attractive right now.
But Westpac chief economist Brendon O'Donovan says we should be careful what we wish for. Lower interest rates probably mean a softer currency and a higher cost of living.
"Households have got a correction to go through whether interest rates are lower or not."
"A 10 per cent drop in the average exchange rate means consumer price inflation goes up about 1 per cent in the coming year. Across all of us that is a real wage reduction of about $1 billion, we'd all be facing higher petrol prices, higher import costs in general."
There goes most of your tax cut.
FLUCTUATING FORTUNE OF SWAP RATES
The interest rate swaps market allows overseas banks to effectively swap cash they raise overseas for New Zealand dollars - giving their investors access to our relatively high interest rates.
On the other side of the transaction it allows our banks to access overseas cash at what have been relatively attractive fixed rates.
They then use the cash to fund their fixed rate lending, including mortgages.
Swap market rates are influenced by offshore rates, supply and demand, and expectations of how our Reserve Bank will move the Official Cash Rate to control inflation (although that relationship becomes less direct on longer-dated transactions such as five years).
For the past few years our two-year fixed mortgage rates have on average been 0.6 of a percentage point above the two-year swap rates.
However, the credit crunch has seen the "spreads" - or the additional amount on swap rates that banks pay for money - increase to reflect the riskier environment.
"Trying to figure out where fixed housing interest rates will go by looking at swap rates no longer works quite so well," says Bank of New Zealand chief economist Tony Alexander.
KiwiBank chief executive Sam Knowles has pointed out that what is happening on overseas money markets also has an influence on the rates offered by his bank and the likes of TSB Bank which also largely funds its lending from local retail deposits.
If the major banks are finding it more expensive to raise funds overseas, they lift their retail deposit rates in a bid to attract local funds.
RATE EXPECTATIONS SHIFT
The financial markets have reacted to Thursday's Budget by pushing back their expectations of when the Reserve Bank will start to cut the official cash rate, but only by a few weeks.
Instead of a September start to the easing, they now see not much more than a 50:50 chance Governor Alan Bollard will cut rates in October. A rate cut by the end of the year is fully priced in, though.
But this is a volatile market.
Earlier in the month, when unexpectedly weak employment data came out, the markets briefly priced in a 50:50 chance that Bollard would cut rates at the next opportunity, June 5.
The view from economists, as distinct from the dealing rooms, has also shifted somewhat.
A Reuters poll of 16 forecasters yesterday found six have pushed back their expectations for the first rate cut, but the other 10 still believe he will start in September.
By the end of March next year the median expectation is that the OCR will be 7.25 per cent, a full percentage point lower than it is now.
Bank of New Zealand economist Stephen Toplis said, "Our central call is still that the bank will start to ease in September, but the risks that it will be delayed, by up to a quarter, have heightened."
Finance Minister Michael Cullen described the debt-market sell-off as an over-reaction, and Toplis agrees.
Neither the October start to the tax cuts, nor the fact that they turned out to be higher than the $1.5 billion pencilled in by the Treasury and Reserve Bank last December, should have come as a surprise.
"Who in their right mind would have thought the Government wouldn't deliver at least as much as expected and possibly more?" Toplis said.
"It is a counter-cyclical Budget but also an election year one. The market has got a bit over-excited. In due course, when the monetary policy statement is released on June 5, a lot of that will unwind."
ANZ National Bank has pushed back its expectation for when official cash rate cuts will start form September to December.
"The economy is a lot weaker than a lot of people, including the Treasury, acknowledge. The Reserve Bank knows that fiscal policy is coming to the party but it will want to wait and see how much impact it is going to have," chief economist Cameron Bagrie said. "I think the answer it is not going to make a lot of difference - $16 a week is going to go out the door pretty quickly."
The caveat to the view that the Reserve Bank would wait and see was that the economy was very weak, Bagrie said.
And it would be conscious of how long it takes for a monetary policy stimulus to work.
Westpac, which for some time has been the market's fiercest inflation hawk, has moved its expectation for the first interest rate cut from September back to March next year.
"Dr Cullen is focusing on the weak growth giving room for tax cuts, and he has a good point there," said Westpac economist Sharon Zollner. "But we are sceptical that the slowdown is really going to knock the stuffing out of inflation when you have cost shocks of this magnitude - like $2 a litre petrol - going on."
Bagrie said the surprise in the Budget was the extent to which the surplus is being run down - from $5.2 billion, or 2.9 per cent of GDP in the current year, to $1.3 billion, or 0.7 per cent of GDP in the year ahead.
"Those fiscal forecasts have a huge amount of downside risk. The Treasury's growth forecasts still look optimistic, and they think they will be able to keep spending increases in the 2009-10 Budget to $1.8 billion. There's just no way."
- Brian Fallow
