The Reserve Bank’s recent increase of the Official Cash Rate (OCR), albeit a small one, heralds the start of a new cycle in interest rates. The significance of this change should not be underestimated. It is around seven years since the OCR was raised and the increase signals the start of a very different economic cycle in which there will be winners and losers.
The New Zealand economy is booming despite COVID, thanks to high levels of consumer spending, construction and strong demand for our exported goods and services. There are signs that inflation is on the rise, and interest rates will continue to increase to keep this in check. This is good news for some people and not so good for others.
Investors sitting on large bank deposits have been waiting patiently for interest rates to rise and reflecting on the good old days before the Global Financial Crisis when it was possible to secure a term deposit at 9%. Those days are long gone and it is not likely we will see a return to such high rates in the foreseeable future. While the OCR will gradually increase over the coming year, there is not a direct correlation between the OCR and bank deposit interest rates. There are a number of factors influencing deposit rates, including the wholesale rates at which banks can borrow offshore, the level of bank deposits and the demand for loans. However, over time, the trend for deposit interest rates is likely to be upward.
Now is not the time to be investing in long dated bonds with a fixed coupon rate. As interest rates rise, the value of bonds falls. That’s because the coupon rate of interest on the bonds becomes less attractive as market interest rates rise and the bonds, if offered for sale, will sell only at a discount. Astute investors may well reduce their holdings of bonds in exchange for shares, which will have a positive impact on share prices.
Borrowers such as house owners and businesses should now consider fixing their interest rate or alternatively budgeting for a significant increase in debt repayments. Mortgage interest rates will not be as low as they are now for the foreseeable future. It would be wise to fix a rate on at least part of a mortgage for a number of years, bearing in mind that if you need to repay the mortgage (for example, if you sell your house) the bank may ask you to pay a penalty for breaking the mortgage. If you are not sure what your future plans hold it can be a good idea to split your mortgage into two or three parts that are fixed for different time periods at different rates. When you look at the mortgage interest rates on offer, you will notice that the one year rates are a lot lower than the five year rates. What you have to keep in mind is that the reason for this is the banks are expecting market interest rates to increase over this time period. If you were to fix your rate for one year you will find that a year from now interest rates will have gone up again. When interest rates are rising it is likely that you will pay more interest by fixing for one year terms over a five year period than if you fix now for five years. So don’t be tempted by the low one year rates unless you are planning to sell your property. If you think you might struggle to pay the five year rate, ask the bank if you can extend the repayment period for your mortgage.
While there is still a lot of economic uncertainty as the world adapts to COVID, there is one thing for certain – we are at the start of a new economic cycle and those who prepare for it will be the winners.