Why we may face higher interest rates in the future - Article by Daniel Glynn from our November Newsletter

It is a strange anomaly that the Reserve Bank of New Zealand has reduced the Overnight Cash Rate (OCR) to 1.75% and this has not affected interest rates at all. In fact the reserve has happened! Banks started to pay their depositors higher rates and longer term mortgage fixed rates rose.

Firstly, there comes a point when banks cannot reduce interest rates sufficiently and still make a profit. This is happening in the United Kingdom, Europe and Japan where it now almost unprofitable for banks to lend money to retail (housing) customers. Instead banks have had to look at alternative ways to make money, through currency swaps, credit notes, commercial and merchant banking, insurance and the like. In New Zealand, the retail market is extremely large and the banks by necessity have to retain higher interest rates to ensure their profit margins are intact.

The other factor affecting longer term rates is the increased likelihood of the Federal Reserve in the USA putting rates up. This has consequences for us in New Zealand as our banks rely on borrowing the majority of the money they lend on mortgages from overseas, particularly Europe and the USA. Our domestic deposit market is too low for our banks to fund our borrowing. There has been a rate increase on the cards for some time for the Federal Reserve. The reason why they would so this is to dampen down inflation, thus preventing the economy from overheating. They have refrained from doing so because of the result of poor jobs figures and world events (read collapse of the Chinese stock market and Brexit) potentially affecting the US economy. However, they have pencilled in a rate increase in December.

Longer term rates will also likely be affected due to recent political events. The surprise victory of the Republicans in the recent US election raises some inflationary concerns. Trump has advocated a protectionist policy, thus isolating the USA from its major trading partners, and perhaps enforcing trade tariffs. This may result in the prevention of free trade and hence raise prices. Also, he has strongly indicated that the US will embark on a major infrastructure spend, which will create jobs and increase the Government deficit. All this spending is inflationary and will most likely lead over the long term to an increase in inflation. When this happens, you can bet that the Federal Reserve will act quickly to raise interest rates in the US to dampen down that inflation.

I would think that we are at the bottom of the low interest rate cycle and that rates will go up. Not great for borrowers, and for those contemplating selling their homes, may see a toughening in the market as a result. Also of concern for home sellers may be the impact of populist politics here, as in the US and UK, people may vote with a single issue in mind. In this case immigration could be the single issue that may dominate the next New Zealand election. This could potentially result in a change of immigration policy, which may slow immigration flows. The housing market may indeed be affected if this is the case, and we will finally see a cocktail of policies and economic levers which will surely lead to a lowering of house prices, which the Reserve Bank Governor has been after.