ANZ July 2010 Mortgage Borrowing Strategy
posted July 26 2010
While floating rates have increased, fixed rates have fallen substantially in the past month, led by the long end. This has seen the difference between fixed and floating rates contract substantially. This raises the obvious question - is it worth fixing now that fixed rates have come down? With so much uncertainty about, especially in relation to the state of the housing market, we still favour the much lower floating rates.
ANZ's View
Floating mortgage rates rose in June in the wake of the RBNZ's OCR increase, but most fixed rates fell, mirroring substantial falls in wholesale rates. The spread between floating and fixed mortgage rates fell for most terms as a result, but it remains high by historical standards. Indeed, although the gap between the floating rate and the 2 year rate has contracted by over half a percent, the gap remains wide at close to 1 percent. Excluding the last 6 months, that's as wide as the gap has been in 10 years, and compares to an average gap over the past decade of minus 0.6 percent. Nor surprisingly, only a small number of borrowers have been prompted to fix their rates following the recent cuts. Generally speaking we tend to agree with this behaviour. Fixing provides certainty, but when it comes at a considerable cost it is far less attractive, particularly given uncertainties elsewhere. It's one thing to pay a certainty premium when the housing market is booming, but it's another thing entirely when the housing market is in the doldrums.
Regular readers will be familiar with our breakeven analysis. Cashflow and affordability are crucially important considerations when it comes to choosing a term. Similarly, it is important that borrowers incorporate plans to increase or decrease borrowing into interest rate decisions. But beyond these considerations, we have not found a better way to compare rates than breakeven analysis. By comparing the choices available, breakeven analysis provides a set of figures showing where rates need to be in future to make two strategies equivalent, enabling better choices. For example, when thinking about the next 2 years, there are several choices you might consider if you wanted to. For example, you might consider fixing for 2 years; fixing for 1 year, and then for another year in 1 year; or fixing for 6 months, and then again in 6 monthly intervals over the remaining 18 months, and so on. Breakeven analysis allows you to compare these strategies against one another. For example, when compared to fixing for 2 years at 7.00%, if you did fix for 1 year at 6.45%, breakeven analysis shows that you would need to be able to re-fix at 7.55% in one year's time for the split strategy to be the better one. the question is, do you think the 1 year rate will rise by 1.1% in the next year? We think it's a line call. We certainly expect the OCR to move higher over the next year, but it will do so only gradually, suggesting if you do "beat the market". it may not be by much. Fixing for 2 years therefore looks a little expensive.
While breakeven analysis is useful when comparing fixed terms, it is less helpful when choosing between fixed and floating. Because there are so many possibilities when you go floating - you can fix at any time - it's more difficult to do scenario analysis. But pragmatism would suggest that if the RBNZ were to raise the OCR by another 25bps at the end of July, as we expect, chances are the floating rate will go up by a similar amount. And with the floating rate only 15bps below the 6 month rate, this makes the 6 month rate a fairly attractive proposition.
While remaining floating or fixing for a much shorter period (like 6 months) will leave you more exposed to rising interest rates, two things are worth bearing in mind. The first is that the term structure of interest rates already has an upcoming OCR rise "built" into it, which is why fixing for a long period costs more. Therefore, when choosing whether or not to fix, your decision should not be made against where rates are now, but rather against where the market expects rates to be in future. IF you think rates will rise more quickly then the market, paying fixed might be worthwhile. But when the market is "pricing in" hefty rate hikes as it is now (our analysis shoes that the market expects 3 rate hikes by December), then fixing may be less attractive.
The second point relates to the slope of the curve, or the gap between floating and fixed rates. As we noted earlier, in the past this has tended to be reasonably small, and often negative. This meant fixing often meant paying a lower rate, at least initially. However, extreme caution on the part of the global investors has seen a large rise in the term premium, and this has come at a time when regulatory changes are encouraging banks to lengthen the term of their own funding. The end result is a significantly steeper yield curve, and that favours depositors over borrowers. Instead of being "rewarded" for borrowing money (with easy access to loans at rates well below the pace of capital gains in housing), household are not being rewarded for putting money in bank term deposits. This has, and will continue to lead to fundamental changes in borrower behaviour.
posted in: ANZ, Interest Rates, Property Market, Investment Advice, OCR, Fix or Float
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