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Welcome to the latest installment of a new feature here on the Fundit blog, where I review the bank’s regular economic reports, and, along with my own views, presenting the relevant points in an easy-to-read format.  I welcome your questions and comments – feel free to send them through to glenn@fundit.co.nz

The effects of the Reserve Bank’s 25 basis point OCR increase have filtered through to mortgage rates, with all major retail banks adjusting their rates in the past week or so. Those of you who read my predictions in the immediate aftermath of the OCR rise will of course want to know how I performed. Ahem. Well, it seems that although I was accurate in my view that longer-term rates would fall slightly, I was incorrect when guessing that the banks wouldn’t pass on the full 0.25% OCR increase to floating rates. As it turns out, they did. The appropriate punishment has been administered, and I promise not to be so careless again.

Actually, this illustrates all too well a point I will be making time and time again: the views of market commentators (one of which I am not, for the record) should be taken with a massive dose of salt. If a view about future interest rates is prevalent it will already be factored into current interest rates – it’s only things that are unexpected that will change economic variables in unpredictable ways. The unfortunate thing about unexpected economic changes is that they tend to be, well, unexpected (at least to the majority of us); which makes predicting them rather difficult.

That little diversion aside, here’s where interest rates are at now (12 August 2010):

Breakeven (Implied Future Interest Rate) Table

Read about what this is, and how to use it, in my first post

Falls in the longer-term rates have probably got a lot of you thinking about fixing now, but remember the market has already ‘priced in’ its consensus opinion about what will happen to floating rates between now and then.

OCR? Margins?

I received a few emails in the wake of my last post asking about the OCR and its relationship to bank margins. For the sake of everyone, here’s a brief explanation for why bank margins haven’t necessarily increased despite there being a bigger difference between the OCR and mortgage rates now than a couple of years ago.

The OCR only applies to the amounts banks hold in overnight settlement accounts with the Reserve Bank. It’s thus a strong determinant of the total supply of money in the economy (and ultimately the retail interest rate you end up paying), but is far from the only factor banks have to consider when setting mortgage rates.

Banks source the majority of their funding from both domestic and international sources, for which they have to pay commercial rates. These rates are typically well above the OCR rate. As a result it isn’t really as simple as subtracting the OCR from a mortgage rate to work out the bank’s margin, because they’re paying more than the OCR for most of their funding.

Why are the commercial rates that banks pay higher than the OCR? It’s a question of risk: rates like the OCR can be considered a loose proxy for a ‘risk-free interest rate’, so any difference between the OCR and a retail mortgage rate isn’t necessarily all gravy for a bank, because they have to expect some defaults. If the difference between the OCR and current mortgage rates is bigger than it once was it probably indicates that the banks expect more defaults, which reduces their ultimate profit margin.

From the banks

BNZ (http://bnz.co.nz/binaries/w050810.pdf):

“But we still see the economy growing near 3.5% next year with increasing capacity issues due to low business capital spending and the labour market tightening we anticipate over the coming 18 months. That means we think the markets are underestimating future official cash rate rises and in fact the current levels of swap rates imply a peak for the cash rate under 4%.”

Tony Alexander thus thinks the consensus market view on future interest rates (shown in the breakeven table above) are a little off. He also mentions that falling long-term rates could induce people to jump off floating and into fixed rates, pushing up those rates as demand increases:

“Eventually a large number of people are likely to jump into fixed and when that happens the risk is the volume of movement causes a spike up in those fixed lending rates. That transition is not imminent but may happen early next year. For myself I would still hop off floating into a two or three year fixed rate.”

Why? Because he thinks the current longer-term rates are underpriced relative to his expectation of OCR and interest rate rises.

Westpac (http://westpac.co.nz/olcontent/olcontent.nsf/content/FM_Weekly_20100809/$FILE/NZWC0908.pdf?Open):

“The decision to fix or float remains finely balanced. Floating rates remain lower than short-term fixed rates at the moment, but they are likely to rise faster as the RBNZ increases the OCR. Fixing, if even for a short term, has the advantage of greater certainty around cash flows, at a time when floating rates could be rising rapidly”

Of course I argue that the fix/float decision is always finely balanced - if it were obvious what to do everyone would do it, and in so doing would change interest rates which would eliminate any advantage from that action. That aside, they speak only truth when talking about certainty: this is the real decision you’re making when deciding to fix or float. Forget any idea of beating the market, if you can’t afford to gamble on an outcome you’ll only gain marginally from at best you should be prudent and fix.