Financial Pictures

We don’t think that the market has grasped the full message of the Reserve Bank’s latest Monetary Policy Statement.

The RBNZ cut the cash rate by 50 basis points to 3.00%, a smaller move than we or the market were expecting, and indicated that any future cuts are likely to be smaller than those seen in recent times. The 525bp of rate cuts since July last year, the steep fall in the currency, and a strong fiscal impulse mean that a lot of stimulus has been applied to the economy in a short space of time, and is expected to drive a strong recovery over coming years. Indeed, their forecasts for New Zealand are positively cheery in the face of a global recession, with GDP growth returning to 4.5% in calendar 2010 and 4.1% in 2011.

The RBNZ’s 90-day rate projection suggested that a further cut in the OCR to 2.5% is likely, though Governor Bollard admitted that there is a high degree of uncertainty around their forecasts for a rapid recovery in growth, and an OCR of 2% is still a possibility.

However, the RBNZ seem concerned about the consequences of taking the cash rate to very low levels. The press release noted that “New Zealand needs to retain competitiveness in the international capital markets,” implying that rates among New Zealand’s peers (specifically Australia) may be a constraint on policy settings here. It’s debatable whether a lower cash rate would truly present a barrier to raising funds offshore – longer-term rates of return are determined by the market, and if international investors demand a premium for lending to New Zealand, then they will charge one. The risk is that further OCR cuts may fail to get traction on longer-term rates – the problem that has plagued the US and the UK throughout this easing cycle.

Nevertheless, the market took on board the message that there is limited scope for further OCR cuts. The 90-day rate and the two-year swap rate have both risen by 20bp since the announcement. There has been little movement in retail lending rates, to the extent that banks had already anticipated an OCR cut of at least 50bp. The New Zealand dollar has also risen by 2.5%.

What’s been overlooked, though, is that the RBNZ’s forecasts are predicated on a much easier mix of overall financial conditions. They project the NZ dollar trade-weighted index to fall to 47.5 in the first half of next year – effectively returning to the all-time lows seen in late 2000 – and to remain at historically low levels for several years to come. The RBNZ see this as a necessary part of the economy’s adjustment process, by improving exporters’ competitiveness and making New Zealand dollar assets cheap enough to attract foreign investors.

Our own forecast for the currency is similar to theirs, and for the same reasons. But a forecast is one thing; making it an essential part of monetary policy settings is quite another. The RBNZ clearly believes that easier financial conditions are necessary, and is counting on the currency to do most of the work for them.

But exchange rates aren’t exactly known for complying with the wishes of policy makers. So if the NZ dollar doesn’t fall in the way that the RBNZ would like, what is their Plan B? Exchange rate intervention is currently in the headlines, with the Swiss National Bank the first central bank to explicitly take this route – but it doesn’t seem a plausible way to achieve a currency depreciation of the depth and duration that the RBNZ expects.

The alternative is to resort back to interest rate cuts. As we have noted, overseas investors may demand a premium for lending to New Zealand. One way that premium can manifest is through higher long-term interest rates; another way is through a weaker currency, which makes it cheaper to buy NZD assets and provides greater potential for currency appreciation in the future. Cutting the OCR to relatively low levels by international standards would be the most effective way to generate a weaker dollar.

We continue to expect a low in the OCR of 2.00% for this cycle. The RBNZ points out that there is a lot of bad news yet to arrive which has been factored in to previous policy decisions. So the appropriate point at which to end the easing cycle is not when the economy starts to recover, but when it stops falling short of (very weak) expectations. Unfortunately, it’s not at all clear that we have reached that point yet. Upcoming releases such as the Quarterly Survey of Business Opinion, retail spending and unemployment are unlikely to support the RBNZ’s story of a rapid rebound in growth from the second half of this year.

We are currently picking a 50bp cut at the 30 April OCR review. In addition to the key domestic data, the RBNZ will have seen the RBA’s rate decision in early April and will at least know what is expected for the early May review. Since we also expect the RBA to cut to 2% over coming months, relative interest rates shouldn’t be a constraint on the RBNZ for too long.

Fixed vs. floating: Despite their apparent reluctance, we expect that the RBNZ will cut the OCR further in coming months, and commit to keeping rates low for a long time, as their hopes for a strong rebound in growth are dashed. Although term funding pressures are leading to some upward pressure on longer-term fixed rates at the moment, we don’t think there’s any urgency to lock into long-term fixed mortgage rates.

Source Westpac Weekly Commentary 16.3.2009

The Fed End Game

People are rightly outraged about the AIG bonuses [um, why not the Merrill Lynch ones that were far bigger and possibly involved outright fraud?] but the amounts involved in that are tiny compared to the size of our problems. I would agree that the bonuses themselves far outweigh their monetary value because they are reflective of an insular, entitlement mentality that has captured the Street and the Treasury Department. Until the culture has been broken we will continue to see a mess.

Anyway, forget all that for a second.

An hour ago the Fed announced it was buying another $750 billion in mortgage backed assets and will start purchasing long term treasuries, the first installment at $300 billion. In short, this is the long awaited “monetization of debt” that people have been expecting, or in other words, they are just printing money to simultaneously try to keep interest rates low and inflation expectations high (those are contradictory I’ll get to it in a second) with the hope that asset values will increase. Ben Bernanke gave a famous speech where he said deflation was impossible in a fiat system because they could just do a “helicopter drop” or in other words, print money. The idea was proposed by Milton Friedman as a way to avoid a depression.

This is potentially the start of the biggest gamble that the US government has taken with its currency since moving off specie and may have profound consequences for decades.

So the idea is that the treasury prints money, the Fed uses that to buy long term bonds to keep down interest rates and encourage investment, and then the money goes into circulation. Theoretically that money will cause inflation and — coupled with low interest rates — people will stop saving money and start buying stuff, getting out of the deflationary spiral and causing universal bliss. There are a few minor problems with this theory.

First of all, it’s a game of chicken. If inflation is going to rise then you don’t want to have bonds, so you’d sell them and cause the yields to rise. The more people that sell, the more the Fed has to buy to keep yields down, meaning the more money has to be printed, meaning the more inflation expectations will rise…etc. This can cause “embedded inflation expectations” which means that people will stop paying attention to reality and cause rampant inflation. This is what happened during the 70s, which ironically is what Friedman won the Nobel prize for, although the embedded inflation expectations in the 70s were due to an external resource shock rather than monetary policy per se. So then at some point the Fed has to stop and raise interest rates enormously to stop inflation expectations. If it does it too soon, well we’d still have a Depression (worse than not having the intervention) and if it does it too late, then our currency would be completely devalued against either other currencies or real goods (if all currencies are devaluing). When is that right time? Well no one has ever successfully used this, so no one knows. I’d argue that there is no right time because they operate on different timescales, and therefore it’s impossible to thread the needle…but their models say differently.

Secondly, if there is a lot of inflation, that needs to go out into wage inflation or else everyone without a lot of assets will just become a lot poorer. To say that our society doesn’t have the structure to have wage inflation take hold is putting it mildly. Also, as my post a few months ago mentioned inflation won’t inflate asset values evenly. Even if inflation takes hold, then housing still won’t increase much in value, but basic materials will skyrocket. It’s likely we’d have all the problems we have today but that it’d harder for most people to afford necessities. The banks still won’t lend very much because people are too indebted, but now the rich market makers will have lots of money so bubbles will form in lots of random asset classes.

In short, by trying to avoid a depression, they are punishing savers and rewarding debtors, and doing it in a way that makes the people that messed up have more wealth.

As the Wikipedia article on the Helicopter Drop states:

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries [in this case we can’t because they have too much power] to give money directly to consumers or businesses [or large investors, which is what this is]. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away.

In essence it is a transfer of wealth far greater and more insidious than any tax increase and in the present environment will most likely be borne the most on the poor and middle class. As my friend succinctly put it after I described the theory (before stating my personal opinion): “so they are, in practice, devaluing all industry and commerce which hasn’t failed.”

There is a chance that they will start down this path and blink because it’s too big, and we’ll have a very fast Depression as they pull the plug and give up. This is literally the last tool they have and if it fails then there is nothing left. There is also a chance that they will continue to do the policy until inflation gets wildly out of control, threatening the security of the US dollar (especially if China decides to sell off its treasuries) or fiat currency in general (the UK started something similar and most countries will follow). This is why gold shot up a ton today. I think there is a small chance that it’ll work as intended, for the reasons I detailed in my series in the fall (here, here, here).

Don’t get me wrong, the steps that they have announced thus far are not large enough to really change things one way or the other. This is merely a $300 billion (well $1 trillion with mortgages) test balloon to try and influence people’s behavior. Of course this is like the 50th thing that they’ve done to manage expectations and those have all failed, and at this point people are being tricked for shorter and shorter periods of time, so the real question is what they will do over the course of the next year when the economy fails to pick up.

If you think we’ve seen a wild ride so far, just know that we ain’t seen nothing yet. This is going to make the moves in the bond and currency markets even worse, which will cause extreme volatility and lead to more failures. Even if the policy eventually works, it’s going to shake the system to the breaking point…whether it breaks and falls apart or rights itself at the last instant, I don’t really know; the entire environment is getting too ahistorical to try and predict. I for one am desperately hoping that people across the spectrum will wake up and start demanding policies that will preserve the integrity of the government, even though that means deflation and a depression. We can work through that, but it’s less clear how to work through the other.

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FIX NOW

And the long version…..

It’s time to fix medium to long term. Over the past few weeks four things have happened to shave the chances of a 5.5% five year fixed rate down to 1% and the chances of a rate less than 6% down to maybe 10%.

1. Overseas sharemarkets have rallied and this is associated with and causing some movement away from fixed interest assets toward growth assets. That means higher interest rates.

2. The Reserve Bank last week went to some trouble to point out their reluctance to keep cutting interest rates much further.

3. Corporate borrowers have been jumping in to take advantage of low fixed rate borrowing costs and fixing for medium to long term periods.

4. There is little evidence of a return of banks competing aggressively for home lending business with strongly discounted interest rates.

This means that if I were borrowing at the moment I would now hop out of floating and opt for a mixture of periods between three years and seven years.

Choosing a mixture would seem to be a good idea given the inherent volatility in income and ability to make extra mortgage payments for some people, plus the sheer uncertainty of the current and prospective economic environment which suggests spreading one’s interest rate risk involves more than just fixing for one term.

Keep in mind however that the chances of someone fixing now being hit with high break costs somewhere down the track seem reasonably slim. Those costs are incurred when interest rates fall – not when they rise.

Given that I am not going to get the lovely 5.5% – 6.0% five year fixed rate I was hoping for, I would fix one-third of my loan for seven years at 6.79%, one-third at five years for 6.49%, and one-third at three years for 5.99%. If I had a small loan or expected bulk repayment 2-3 years out I would opt for a two or three year rate.

Frankly it is very much a matter of personal choice which mix and match combination one takes. All that really matters for the moment is that the chances of rates falling from current levels are minimal. So given the goal I stated last year for 2009 of picking the time when fixed housing rates would be at their low point, this is almost certainly that time.

Are rates going to now rise quite quickly? That is the new big uncertainty and it depends massively upon what happens with the global economy and its growth/shrinkage expectations over the next few weeks and months. In other words – unclear. Take it as it comes in this uncertain environment.

Source: Tony Alexander BNZ

Interest Rate Outlook

How low will it go? This question plus when should I lock my rate in ‘long term’ are the big questions everyone are asking right now.

The Reserve Bank are due to meet for the next interest rate review on 12 March with most economists predicting another 0.75% to 1.0% decrease in the Official Cash Rate, (this is the rate that banks fund their variable interest rate off).

Accordingly, we should see variable and 6 month fixed interest rates fall even further but don’t expect to see these cuts flow through to the longer term fixed rates quickly. New Zealand banks still need to raise much of their long term funding from overseas, as such they are paying quite a premium to do so given the ongoing global credit crunch meaning that the reductions will be slow to flow into this sector, (allow 4-6 weeks).

However, at some point there will be a long term advantage in fixing in for 3-5 years at the rates that will become available as the above cuts slowly filter through. The reality is no one can give you the exact best time to switch from variable or 6 month fixed to 3-5 year fixed rates as it is a moving target.

Personal circumstances will influence each decision but in general terms we believe that the long term fixed money (5 years) will only ease by perhaps another 0.50% and should they again fall below 6% many of our clients will see this as very attractive money giving them some real certainty in their finances for the foreseeable future.

Of as much importance, where possible consumers should look to keep their monthly repayments at the same amount they have been paying when coming off higher fixed interest rates as opposed to reducing their repayment and keeping their term the same. Adopting this strategy will save you thousands of dollars in interest as well as cutting years off the term of your loan as you in effect are paying more off the principal than you are now required to.

Getting the mix between locking the bulk of your money in for the ‘probable’ sub 6% long term rates and keeping your repayments at their previous higher level will give clients some real long term savings.

What’s Hot
Variable Interest Rates and fixing for 6 months at a time is definitely what is hot right now. Everyone is trying to pick the bottom of the market with interest rates which historically has proven about as easy as predicting the Wellington weather. Accordingly, most consumers are opting for a wait & see mentality. Given 6 month money is over 0.50% cheaper than variable rates many are opting for this strategy which gives the best current pricing while not committing you for a long time.

Deal of the Month
We are heartened by this month’s deal as it actually shows banks will still open their vault for the right types of clients. Our client is self employed with his own very popular restaurant for which he wants to extend due to capacity issues. Despite the owner’s home already being geared to 80%, we were able to provide strong historical financials, up to date interims and well documented financial projections, as such we were able to raise the funding for this business as the bank could see a clear increase in income would result.