Beware of 'low' fixed mortgage rates

OPINION: When it comes to the interest rates cycle, there are many interesting points and pitfalls that always catch a lot of people out, writes Tony Alexander this week.

Perhaps the most classic is the misplaced belief that floating and fixed interest rates move together.

There certainly are periods when both are rising and falling together. But when the interest rates cycle is moving from upwards to downwards or vice versa, fixed interest rates always move in advance of floating rates.

This means, for instance, that while floating rates are still low and going nowhere, fixed rates are usually rising. This has played out in spades over the past few months.

Back in March, floating mortgage rates were around 6.5 per cent and the likes of BNZ's five-year fixed housing rate was 6.49 per cent. Now, seven months later, floating rates are near 5.7 per cent while the five-year fixed rate is at 8.75 per cent. Fixed rates have soared while floating rates are falling.

This has happened because fixed rates tend to reflect where floating rates are expected to sit in the future, on average. So as soon as the markets start to expect floating rates to rise, fixed rates tend to go up right then – even though floating rate rises may not be expected to occur for quite some time. In fact, we are unlikely to see floating rates rising until the first half of next year.

So, as we have been pointing out for seven months now, if the only reason you have been floating is because you are waiting for a good point to fix, there has been zero point in waiting because fixed rates were (in our case accurately) predicted to go up.

But, where things are now, to jump from floating to fixed is too big an ask.

So if you have not fixed by now, you are too late for this cycle. Your incentive is to float and go along for the ride – which brings us towards the next interesting point in each cycle.

Now that it is more widely accepted that floating rates will be rising next year, we start to get scary forecasts of where they will go to. Our view is that the Reserve Bank will act tentatively over 2010 for fear of scaring the economy back down again. We forecast that from 5.59 per cent at the moment our floating mortgage rate will have reached about 8.5 per cent come the end of 2011 – not 2010.

But already there are forecasts of floating rates at 9 per cent next year. Some people are trying to scare the punters. Maybe it is the same silly people who predicted house prices would fall 40 per cent.

We think the next really interesting part of the interest rates cycle will come at some point over 2012-13. What will happen then is that floating rates will probably be getting near their peaks for the cycle and there will be expectations of them falling again as the economy slows down.

Those expectations will place downward pressure on fixed rates from levels higher than they are now.

That will open up an incentive for cashflow-focused people to hop off floating rates above 10 per cent into fixed rates near 9 per cent.

At that time we anticipate making the same comments as early last year and in mid-1998 when there were large gaps between floating and fixed interest rates – stay away from fixed rates.

When floating rates are high enough to be really painful, they are high enough to push fixed rates down, and they are high enough to crunch the economy so much that monetary policy will eventually ease a lot and those floating rates will fall sharply. This happened in 1998 and 2008.

This, then, is the next period those who are now floating their interest rates need to keep a keen eye out for.

Watch you don't make a big mistake and fix in three to five years at a rate higher than one you are currently not willing to touch with a barge pole because it is so much above the current four decade-low floating rate.

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

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