Higher floating rates coming

OPINION: Each month we survey the 20,000 people who receive our Weekly Overview asking them how they see the economy in the coming year and what is happening in their industry at the moment, writes Tony Alexander this week.

The latest survey largely collected on Friday showed a massive net 56 per cent of respondents feel the economy will get better rather than worse in the coming 12 months.

This is the highest result in our survey, which has been running five years. Because of the strong correlation between our results and those from a more detailed survey which appears at the end of the month and attracts attention in the financial markets, there are some clear implications for interest rates and the exchange rate.

The first is that unless the Reserve Bank surprises almost all of us by cutting their official cash rate from 2.5 per cent tomorrow morning, wholesale interest rates are likely to continue to drift up over the remainder of this year.

So, too, will the currency. For exporters, this means one should still be looking for the occasional dips in the New Zealand dollar to get some extra hedging on board.

For borrowers, the situation is very interesting. First, with economic growth prospects improving around the world, medium-to-long-term bank borrowing costs will rise so fixed lending rates will continue to increase.

Three-year fixed housing rates, for instance, have already gone from 5.99 per cent in March to 7.45 per cent now. This shows yet again the error so many borrowers make they sit floating until the floating rate rises then switch to fixed thinking fixed rates rise with floating rates. At turning points in the interest rates cycle they never do!

Second and this is the interesting bit there could be a change in bank mortgage pricing strategies. Traditionally, Kiwis have borrowed fixed since fixed rates appeared in the early 1990s.

That is because the fixed rates often are more attractive than floating rates, partly because banks have tended to compete for new customers with fixed rates.

In Australia, banks compete with discounted floating rates so around 80 per cent of borrowers usually float. It is the opposite here.

But one major bank has just cut its main floating rate 0.6 per centage points so it sits 0.10 per centage points below BNZ's lowest floating rate.

At the same time they raised their fixed rates 0.2 per centage points or so. In accepting a reduced margin on floating rate lending and getting a slightly higher margin for fixed rate lending, the bank may be trying to encourage borrowers to go floating.

In the short term, everyone wins as borrowers get a lower rate and banks actually make more margin on average because floating margins have traditionally been double fixed rate margins.

The potential shift in the competition fight to floating could be because of a fear that in the next few weeks or months we see a repeat of what happened in late March.

Back then so many people switched suddenly from floating to fixed the banks could not do their normal hedging by switching their own borrowing from floating to fixed as quickly.

Lending fixed while sitting floating or vice versa is dangerous in New Zealand. So maybe a desire to limit people switching by reducing the incentive lies behind the rate play.

We shall see whether other banks follow suit perhaps with most awaiting the Reserve Bank's words before changing pricing strategy.

As noted above, for borrowers the lowering of floating rates is good. But be warned. Come the end of 2011 we expect floating rates to be around 3.5 per centage points or so above current levels.

So make sure you budget for such a jump if you forgo fixing now for the cashflow benefits of floating.

Optimally keep your repayments up and get principal down as much as possible in readiness for the eventual end of these four-decade lows in floating rates. Tony Alexander is chief economist of the Bank of New Zealand (BNZ).

» Tony Alexander is the chief economist for the Bank of New Zealand.

- © Fairfax NZ News