Interest rates - a constantly changing landscape

Dominick Stephens

Westpac chief economist Dominick Stephens looks at a key financial variable that affects farmers - interest rates.

For a long while, the Westpac economics team has warned that interest rates cannot stay low forever. It has long-anticipated a construction boom and double-digit house price inflation.

It reasoned that as these things normally generate inflation pressures, the Reserve Bank would be required to increase the Official Cash Rate to 5.5 per cent.

Until recently, financial markets saw things differently. Market pricing delivered longer-term fixed interest rates that were only slightly above floating or short-term rates. In effect, markets did not "believe" that the OCR would go up by much.

Westpac felt this created an opportunity for borrowers. By locking in reasonably low interest rates early, borrowers could avoid the worst of the proposed interest rate cycle. When asked, it recommended that borrowers fix their interest rates rather than float.

How things have changed. Financial markets have done an about-face. Longer-term fixed rates have risen very sharply in recent months, first on wholesale markets and then for mortgages. Long-term fixed rates are now significantly higher than short-term rates.

There were two key developments that prompted the markets' change of heart. First, the United States Federal Reserve's announcement that it may soon wind down the pace of Quantitative Easing (money printing) caused a major realignment of the world's currencies, including a drop in the New Zealand dollar.

The lower New Zealand dollar has already pushed up prices for some imports, such as petrol. If it continues to do so, inflation will rise and the Reserve Bank will have to hike the OCR early.

Secondly, New Zealand's economic data has been on a tear lately. Yes, the drought knocked the economy for six and that showed up as weak GDP in the June quarter. But there is a wide swathe of evidence showing the urban economy did well during and after the drought, while many parts of the rural economy have recovered remarkably quickly since then. For some districts, news of a high milk payment this season has buoyed confidence - our latest forecast is $8.30 per kilogram of milk solids.

So what does all this mean for farmers? In a nutshell, long-term fixed interest rates no longer stand out as the better deal. There is very little difference between fixing and floating.

If you opt for short terms, your interest rate will be low for a while but may shoot up in the future. If you opt for a long-term fixed rate, your payments will be somewhere in the middle throughout. It is not obvious which strategy will result in lower interest payments overall.

At this stage, Westpac suggests the "fix or float" decision should depend on the risk tolerance and cash-flow needs of your business, rather than attempting to beat a market that seems pretty fairly priced.