Interest rates and the year ahead

There is no doubt about it – Christmas is a magical time, filled with love and friendship and happy moments, especially those encompassing the opening of presents! It's also a time for reflection on the year past.  

This year has brought many changes. Banking policies such as loan-to-value ratio policies were introduced. New taxation legislation (the bright-line test) was enacted. Changes were made by the Reserve Bank to New Zealand's official cash rate. All of these factors have different effects on the interest rate market, the property market and consequently, our behaviour.  

Over Christmas, people will be looking at the year coming. Around this time, many clients review their financial circumstances and turn their attention to their own mortgages. The big question many ask is what is going to happen to interest rates? Should people continue with their loans at their existing interest rates, break their loans and re-fix at lower interest rates or maybe float for a while?

I've a keen interest in understanding economics 101 and how that affects interest rates. If you've been following my last two blogs ('Dollars, Sense and Interest Rates' and RBNZ and Interest Rates') and/or have attended our Property School, you will probably have a good idea on where I think interest rates are heading and why.  

Right now, with respect to interest rates, I'm keeping my beady eyes on:

•  Household debt growth
•  Retail performance
•  Construction and associated industries assessments
•  Dairy outlook
•  Export forecasts
•  Housing market values
•  Immigration projections
•  Labour market expectations 
•  Wage growth expectations

I've given up entirely trying to predict the currency markets. I mean the OCR decreased on 10 December 2015 and all things being equal, our dollar should have dropped. Instead it increased which goes to show human beings and their behaviour can screw up all your best thought-out predictions!

Aside from the above factors, I've been wondering about inflation. Right now our inflation sits at 0.4%. That's a big shift away from the 1.6% the Reserve Bank forecasted a year ago. More to the point, inflation is not growing. Nor do I think it's going to grow to the level targeted by the central bank in its forecasted timeframe. I've given my reasoning for this in prior blogs so won't cover this again but suffice it to say, you cannot fight a new problem with old tools. The issue is deflation, not inflation and the printing of money and the continual lowering of central bank rates will not be a cure methinks.

In considering inflation, I've been reading about expectations from the Australia, USA and China markets. These economies affect our own which in turn affects New Zealand's economic growth and inflation. For instance, China isn't expected to be ordering as much as it previously did from Australia. New Zealand's largest export destination is China. Next is Australia. The main trading partner for Australia is China. Hence, all eyes are on China. Its behaviour has a direct effect on our export market, which in turn has an effect on our economic growth and inflation rate experienced.

Where does all this leave us with respect to economic growth, inflation and interest rates?
First, in reviewing the OCR at the next due date of 29 January 2016, our central bank will take into account all of the factors I've previously mentioned. It will also turn its attention to what our dollar is doing. As expected, the US Federal Reserve tightened on 17 December 2015. This did not have the effect of weakening our dollar which I imagine the Reserve Bank would have desired. This is going to make it even more challenging for the Reserve Bank to achieve its inflationary target. If it cannot reach the target, it's unlikely to increase the OCR. Rather, in my view, the opposite will occur.

Secondly, when forecasting NZ economic growth and inflation, the Reserve Bank will be reviewing the effects the El Nino weather patterns are having, the impact surplus of food on the world market has on prices, the increase experienced in New Zealand's unemployment rates, the growth in population New Zealand is feeling and the subsequent surplus of labour and its associated effects such as low or no wage growth. All of these factors could see the Reserve Bank take action in decreasing the OCR, which I'd expect will mean floating and short-term rates will fall further.

Turning our minds to long-term rates, what will affect these?
Ultimately, I believe, offshore events. If offshore lenders charge our New Zealand banks more to borrow funds, those increase in costs will be passed onto us as borrowers in the form of higher interest rates. This means eyes will be on the further tightening actions the US Federal Reserve takes (if any) and the impact these moves have upon our own dollar. If additional tightening does occur, the USD is forecasted to rise and the NZD to weaken. Upward developments (if any) in Europe's economies and financial markets and the ultimate effects that result (e.g. increase in offshore interest rates) will also be watched.

In summary, no one that I know has ever accurately forecasted interest rate movements all of the time. All that we can do is take some of the factors operating in our economy and make a best guesstimate, which is likely to be right 50% of the time and wrong half the time. 

When I think, however, about the anticipated state of the labour market,  the effects of El Nino, dairy price falls and a slowing of growth in China and a subsequent pull back in ordering, I think the Reserve Bank will need to move the OCR downwards in 2016 to induce growth and hence met inflation targets. Then again, construction (housing and infrastructure) spends, along with good growth in the services sector and tourism, may mean my prediction is incorrect. Take it with a grain of salt. If I am right, however, a likely outcome of this will mean variable and short-term interest rates will follow. I'm, expecting the Reserve Bank will want to play a wait and see game so if the OCR is reduced, I'm thinking it will be later on in the year … after April.

As for long-term rates, the jury is out. There are just too many competing influences. Assuming overseas events see economies improve, there could be upward pressure resulting in long-term rates lifting. As always, I recommend the use of risk mitigation tools such as interest rate tranching, lines of  credit being available and of course, having a reserve set aside.