Last week the Reserve Bank of New Zealand (RBNZ) left its Official Cash Rate (OCR) unchanged at 1.0%. This was contrary to a high expectation for a 0.25 percentage points cut and sparked speculation we may have seen a low in bank lending rates, at least for now.
If true, that would disappoint the borrowers of over NZ$37 billion in residential mortgages rolling off their existing fixed rates in the final quarter of 2019*. Let’s look at some of the factors influencing residential mortgage rates, including the upcoming publication of the RBNZ capital review, which illustrates the OCR is just one of many.
Cost of bank equity and debt:
Banks fund their lending through a mixture of debt and equity with the cost feeding through to their lending interest rates.
Post the GFC, regulators concluded banks were too dependent on unstable sources of funding (e.g. short dated money markets which were unreliable) and had inadequate capital to deal with crises. In response, regulators increased minimum bank equity requirements and introduced measures to improve bank liquidity (stable funding).
- Minimum Equity Requirement: Banks now hold more equity but in New Zealand the minimum requirement is likely to increase again with the RBNZ’s capital review, due in early December. That would reduce returns on equity, so expectations are banks will respond by increasing cash profits. Simply, banks may increase lending rates, reduce deposit rates, or both to increase their margins.
- Improved Liquidity: Regulation now requires banks to be majority funded by longer dated bond issuance and “sticky” term deposits. This reduces the risks of a run on a bank and exposure to more fickle short dated money markets.
- The cost of longer dated bond issuance depends on domestic and global corporate bond market conditions. A higher cost generally leads to higher bank lending rates. The cost has been close to unchanged this year supported by favourable corporate bond markets.
- A large gap has developed between the OCR and term deposit rates. As discussed here the correlation between the OCR and term deposit rates has reduced as banks compete for savers money. It means bank term deposit costs have not fallen in line with OCR cuts. That may limit banks’ willingness to pass through OCR cuts to lending rates.
Credit and sector risk:
The minimum equity a bank is regulated to hold depends on the perceived credit risk of its lending. Essentially, banks must hold more equity against higher risk lending. The good news for lower loan-to-value owner occupier residential mortgages is post the RBNZ review they will likely remain the optimal sector for bank lending, albeit the required equity will still rise.
Other factors may come into play. Banks may price less (or more) aggressively for lending to sectors where they have large (or low) exposures or where they wish to reduce (or grow) exposure. One example is where RBNZ rules cap lending growth rates to certain sectors (e.g. loan-to-value and investor lending) which could lead banks to target higher returns to fill their allowance.
Market interest rates:
Both floating and fixed mortgage rates reflect the pricing factors discussed above. Excluding changes in these factors, floating mortgage rates will generally follow changes in the OCR, but fixed mortgage rates will follow changes in wholesale market interest rates, i.e. a 2yr fixed mortgage rate will follow the 2yr market interest rate. This market interest rate reflects expectations for the future path of short dated interest rates (including the OCR). This year market expectations have consistently been for an even lower OCR. That has resulted in 2yr fixed mortgage rates falling more than floating mortgage rates (see chart below). The reverse would be true however if market expectations were for a higher OCR.
Conclusion:
In conclusion, when deciding whether to fix, and for how long, borrowers need to be cognizant of the myriad factors influencing mortgage rates, and not just the OCR.
That said, it is likely most of the NZ$37 billion of residential mortgage borrowing rolling off existing fixed rates during this quarter will reset at lower fixed rates. That should translate to lower interest costs for those borrowers, making for a nice Christmas present.
* see RBNZ statistics here.