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Dwindling liquidity in the local interest rate swaps market is likely to put upward pressure on mortgage rates, market analysts warn.
As it stands, the wholesale market is pricing in official interest hikes that are well beyond the Reserve Bank's forecasts, and those of the main commercial banks.
A swapis a derivative contract - an agreement to swap a fixed rate of interest over a period of time with a floating rate.
Harbour Asset Management fixed income and currency strategist Hamish Pepper said the swaps market had become illiquid as the big overseas hedge funds took to the sidelines.
"They (overseas funds) are not around at the moment," Pepper said.
"They have not had a great amount of success in the New Zealand market and there is so much going on overseas, so we are left with a market with a bit of a liquidity vacuum.
"It means that the market is now pricing the official cash rate to go well through four per cent - this is something like 60 to 80 basis points up from the peak that we got from the Reserve Bank (3.4 per cent) in their forecasts."
Pepper said it was hard to disentangle the impact that illiquidity was having on the market from true market expectations.
"It (the lack of liquidity) has pushed up wholesale rates which, if it persists, then puts more pressure on mortgage rates to rise.
"We have started to see banks push up mortgage rates to essentially try and re-establish margin because if wholesale rates continue to push up, then the banks have to accept a smaller margin. That's the dynamic," Pepper said.
A wave of mortgage rate hikes followed the Reserve Bank's 50-basis point increase in its official cash rate (OCR), to 1.5 per cent, on April 13.
ANZ strategist David Croy said the world was seeing a "synchronised" tightening of monetary conditions, with interest rates rising from very low levels in most countries.
New Zealand's OCR was just 0.25 per cent last August. It now sits at 1.50 per cent and is heading to 2 per cent and beyond.
There has also been a big shift in market liquidity with central banks going from quantitative easing to quantitative tightening, Croy said.
Talk in the market about Japan selling US treasuries had introduced another element of uncertainty, Croy said.
"That sort of flow might be easily absorbed under normal market conditions, but if that's happening against the background of quantitative tightening that is about to begin, then all of a sudden those types of flows can really work to exacerbate things.
"So really we are just in the early to mid stages of a big cycle shift, and I guess people have just been caught out."
Pricing in the NZ overnight indexed swaps has the official cash rate hitting 4 per cent by April next year, 4.25 per cent by July, and 4.5 per cent by end 2023.
"Not only is that a long way from where we sit right now but it is also pretty high compared to where it was pre-Covid (1.0 per cent)," he said.
Economists at the big commercial banks see the OCR peaking at 3 or 3.5 per cent next year.
Meanwhile, the one-year swap trades at 3.66 per cent, the two-year at 3.86 per cent, five-year 3.99 per cent and the 10-year at 3.97 per cent.
"If you look at how swap rates have risen since the last round of mortgage rate increases from the major banks, we are likely to see more upward pressure on mortgage rates in the coming weeks if swap rates stay here," Croy said.
Croy stressed that a synchronised global tightening was an important dynamic.
In the past, New Zealand had eased while others had tightened, and vice versa.
"It's in those periods where you have enthusiasm from the global players to come into our market and put on a trade.
"Today if you are a swaps investor or a bond trader, there is really no place to hide from rising rates."
Independent economist Cameron Bagrie said a 4.5 per cent OCR by the end of 2023 looked unlikely.
"But the market is saying that, because there is a distinct lack of liquidity, and at the moment it is starting to trade somewhat dysfunctionally."
Central banks stepping up their rhetoric had seen interest rates head north.
He said the "usual suspects" in the local market had "chosen to play in other sandpits".
"You have got a global theme going on here, so why would you play in a peripheral market?
"If the New Zealand story becomes really conclusive, then you might just step up and have a bat, but at the moment the New Zealand story does not look any different to what we have seen in most jurisdictions around the globe.
"If you want to step up into the batter's box, you want to ensure that you have a really liquid market that you are batting in.
"There is extraordinary tightening priced in relative to what the Reserve Bank is saying, and relative to what the New Zealand household and the New Zealand household market can sustain."
The market has the Reserve Bank "firing bullets" for every monetary policy meeting for the next 18 months.
"Do I think the New Zealand economy can sustain that sort of tightening that is built into the market at the moment," Bagrie asked.
