BNZ thinks floating rates about to rise

BNZ says that despite what the Reserve Bank is predicting the market has recently moved to price at least 50 basis points of Official Cash Rate (OCR) hikes in the coming 12 months.

"This is moving toward our own expectations of 75 basis points of hikes in the year ahead, following a first 25 point hike in March 2014."

BNZ believes the market under-estimates the pace of ‘normalisation’ of the OCR in coming years.  "We see a steady progression of the OCR to a cyclical peak of 4.50%, by mid-2015."

Its view is based on the premise the economy is now showing broad-based strength, against the backdrop of limited excess capacity to absorb growth. This should lead to inflationary pressures down the track, as should the gradual decline in the NZD that we see unfolding next year. BNZalso sees potential for price pressures resulting from momentum in the construction sector to feed through to broader inflation.

The following is BNZ's view on interest rates

Outlook for Wholesale Fixed Rates

We continue to see higher wholesale fixed rates ahead. Dips along the way are still inevitable, but we think these may be relatively shallow and short-lived. Increased flow from small to medium-sized enterprises and the mortgage book, hedging against future rate rises, should limit dips in yield.

There is still plenty of potential hedging demand in the real economy. The most recent RBNZ data shows 75% of all New Zealand mortgages are still floating or fixed for less than one year. We see a similar trend in small to medium-sized business borrowing.

Despite the recent sharp run-up in yields we still see value in hedging interest rate risk over a two to five year time horizon. That said, ‘value’ has been significantly reduced by the rise in yields in the past two months. In addition, significant flow in five year wholesale rates has pushed them to relative ‘expensive’ territory compared to three and four year rates.

For example, the stated ‘fair value’ for three year wholesale rates is 3.95%. This is the level at which the borrower would be indifferent between ‘fixing’ at that rate, or paying the floating 3 month bank bill rate over the period (assuming our forecast OCR trajectory). The actual current three year rate is 3.53% i.e. close to 40bps below ‘fair value’. On this basis, five year is around 20bps below ‘fair value’.

However, in addition to looking for ‘value’ the decision to hedge interest rate risk may also be motivated by the desire for ‘certainty’. This will be particularly important for businesses who may suffer stress above certain outright levels on floating rates.

It is also worth noting that the recent run higher in wholesale rates is consistent with our previous analysis showing yields historically move higher 9-months (on average) ahead of OCR hikes.

Long-End Wholesale Fixed Rates

Long-end wholesale rates recently spiked higher, following US equivalents.US 10-year yields moved more than 90bps higher from early May, taking them above 2.70% in early July. The catalyst had been comments from the US Federal Reserve outlining in more detail the path it will take to reign in its highly accommodative monetary policy.

US yields now likely incorporate the following view:  that the Fed will ‘taper’ its asset purchases, under its QE policy, from September this year; that additional purchases will cease mid next year; that the Fed funds rate will be raised from close to 0% in 2015.  However, this trajectory is still highly dependent on US data delivery over the prevailing period.

We therefore see plenty of opportunities for continued volatility in US long yields (and by implication NZ long yields). We see US 10-year yields in the process of establishing a higher 2.25%-3.00% range. Consistent with this, we see the potential for NZ 10-year wholesale rates to be as high as 4.85% by year-end, before some stabilisation next year (assuming some stability in US long yields).

We continue to think that short-end (2-year) rates will move higher faster than long-end (10-year) in 2014. The difference between these two rates (currently 1.35%) should therefore decline toward 0.50%. This should reduce an inherent disincentive to ‘fixing’ further out the curve. However, we would caution that by that time the entire rates curve will likely also be higher.

Funding Costs to Provide Only Marginal Relief

There have been some recent marginal reductions in bank funding costs. ‘Expensive’ GFC wholesale funding has rolled off and been replaced by lower-cost wholesale funding.

However, the RBNZ’s post-GFC regulations have ensured that retail deposits now make up a much more significant component of banks’ funding.  Therefore to see further declines in bank funding costs would likely require a drop in retail funding costs. This may be difficult near-term in a highly competitive environment.

In addition, the regulation-driven ‘wedge’ between the OCR and borrowing rates is now fairly permanent, in our view. Any reduction in funding costs would be strictly at the margin. Borrowers should therefore not rely on significant declines in bank funding cost to offset the likely rise in yields in the year ahead.

Summary

Recent sharp rises in wholesale fixed rates have significantly eroded the ‘value’ available in hedging interest rate risk. That said, based on our OCR trajectory, reasonable value can still be seen in two to four year fixed rates. In addition, ‘fixing’ offers the advantage of ‘certainty’ of outcome over the medium-term. Dips in wholesale rates (as currently being experienced) will still occur. However, we do not envisage these being extensive or prolonged, on a path to higher wholesale rates by year-end and beyond.