The tide has turned

Published: Mon 14 Nov 2005 11:54 AM
The tide has turned
Subscribers to our "just-the-facts" service will have noted a dramatic turn in both the swap rates and the debt market, in the charts that form the basis of that service.
Clearly, and across the board, we are seeing rising rates at a fundamental level.
This means the recent sharp rises in fixed-term mortgage rates will continue for a while yet. In fact, the wholesale markets have priced in more than has been passed on so far in those mortgage rates.
For example, since early September, swap rates have risen about +0.6% for the 1 year term, whereas banks have only passed on about +0.4%. The pass-though for terms 2 years to 4 years appears even, but for 5 years less than +0.3% has come through even though swap rates have risen +0.6%.
Expect more fixed-rate mortgage increases to come.
Government stock secondary debt yields have risen strongly over this period in the 1 - 5 year issues, although swap rates have gone up more, also supporting the "more to come" senario.
And there's even more. The money markets are pricing in more than a +0.25% increase for the 8 December OCR review. It will be important to keep a close eye on 90 Commercial Bill yields to see whether they are doing more than just anticipating another 0.25% on 8 December, or signalling an even higher increase. If these markets stay at a 0.50% premium (or higher), banks may feel pressed to raise floating mortgage rates even without an OCR increase.
Although there is a short lag in the pass-through of wholesale money costs to mortgage holders, there is a big lag for term deposit holders. Typically Government bond yields are at a discount to bank term deposit returns, usually in the 0.5% range (over the medium term). This is understandable in terms of the lower risk Government securities offer.
However, with the quite quick run-up in Government bond yields, these premium have narrowed, or even been eliminated in some cases. For example, you can get 6.8% to 7.0% for a one year bank term deposit, which is what a 2006 Government bond will yield. For a two year term, the Government bond will return 6.7% whereas the average bank TD less than 6.5%.
Clearly the banks are going to have to move their offers or see funds leak out to the moneymarkets, attracted to higher returns for lower risk/higher quality investments. To restore the usual premium, we can expect 1 and 2 year bank TD's to rise to the 7.25% to 7.40% range. But that is assuming moneymarket yields don't keep rising.
Similarly, for non-bank financial institutions, the risk premium for their term deposits has fallen markedly in the last few weeks, at a time when the actual risks are rising. We would expect finance companies will have to start offering up to 1% more to reflect the current realities. However, we do expect some lag before depositors realise the risk premium is moving against them. And, the level of loan demand they face will influence their rate offers, especially if it softens.
The most important point in all this is that given the growing unsustainability of the New Zealand economy, overall risk premiums may well increase at the same time rates are being increased - a double whammy. We are starting to see markets price in these factors.
Hold on for a harder-than-expected landing. We could be entering a period where the price of money is significantly higher.
The above is just opinion, of course. You are encouraged to review the facts and form your own conclusions.
14 November 2005
David Chaston

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