Explanation of Rising Interest Rates – Good Returns

Independent economist Tony Alexander discusses how banks are adjusting mortgage rates.

Friday, July 21, 2023, 1:06 p.m.

By Sally Lindsay

There is now confusion over the bank’s recent hike in fixed mortgage rates, even though the Reserve Bank said in May that it didn’t feel the need to raise interest rates any further.

Banks raised fixed rates again, even though last week’s position, which was fully priced into fixed-rate bond pricing in the financial markets, remained unchanged.

“If a bank makes a loan at a fixed rate for two years, it will not fund that loan by borrowing at a variable rate.

“Banks finance their loans by borrowing from the wholesale market at a two-year fixed rate. This is called the swap rate.

“Two-year swap rates rose from 5% in the second week of May to almost 5.6% in the first week of July.

“This 0.6% rise was not driven by renewed inflation concerns in New Zealand. Indeed, local indicators of inflation expectations and capacity pressures have fallen significantly.

“Rather, rising domestic borrowing costs are being driven by rising US interest rates.

“U.S. wholesale borrowing costs rose in June and July, largely on the back of surprisingly strong labor market data.

“Thus, short-term fixed mortgage rates, which most people are interested in and borrowing from in our small economy, are primarily influenced by changes in the official cash rate, developments in the US, and changes in bank margin targets.

“Although we stick to the two-year time horizon, the key points to note regarding the impact of the Reserve Bank’s official cash rate are:

• The change in the two-year mortgage rate is caused by the change in the two-year wholesale cost of borrowing money for banks. This two-year swap rate is determined not only by where the official cash rate currently stands, but where it is expected to be on average over the entire two-year period.
• If inflation rises and investors start to expect monetary tightening, they will ask borrowers for additional compensation by locking their money in for two years rather than ride on higher floating deposit rates.

“Variable deposit rates (e.g. 90 days or less) are heavily influenced by the current level of the official cash rate.

“Swap rates rise before monetary policy is tightened. So in 2021, the one-year fixed mortgage rate rose from 2.29% to 3.19% in the period from January to early October when the cash rate was 0.25%. The two-year rate rose from 2.49% to 3.59%.

“This is going to be important going forward. The current fixed rate reflects our expectations of what the official cash rate will be in the next 1-5 years.

“The market is pricing in monetary policy not easing until the second half of next year.

“Then, fixed rates would fall even though it would still be months before the Reserve Bank cut cash rates.

tag: Tony Alexander

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