Another Interest Rate Cut - What's Going On?

Interest rates in New Zealand are at their lowest in living memory.

upanddownOn 11 August 2016 The Reserve Bank of New Zealand cut the Official Cash Rate by another 0.25% to just 2.0%

The Governor also strongly indicated that there will be further cuts. A chart they provided had a figure of 1.75% in the future. That chart and the words Mr Wheeler used in the announcement, were strong indicators there will be further reductions.

To date the trading banks' response has been to reduce lending rates by about half the OCR cut. Some increased the term deposit rates they are offering. And the value of the Kiwi dollar increased against most major currencies.

In the past a cut to the OCR generally resulted in a cut in interest rates for both borrowers and lenders and the currency devalued, but not this time. So what is going on?

Remember we are in uncharted waters here. No one in New Zealand has experienced conditions like these before.

Our reading is that the the forces of supply and demand are at work on New Zealand interest rates. We suspect banks have decided they have to increase term deposit rates because they are losing deposits. It certainly wont be because they feel sorry for depositors. We know more and more people are looking for higher returns than they are getting from the banks. Some investors who have never considered an alternative to bank term deposits have recently begun actively considering other places to put their money.

The banks must hold a proportion of the money they lend out in the form of liquid assets such as retail deposits, they can't get around it. If their liquid assets decline it reduces the banks' ability to make loans, and that impacts their profit. So they are paying more to try and attract more money and keep a higher proportion of what they've already got.

On the other side of the coin the booming residential property market means demand for mortgages is still strong. So the banks don't need to reduce mortgage rates to keep their lending ticking over. Mortgage interest rates are very, very low compared to what most of us are used to paying.

But Historically ...

Many seem to be thinking that interest rates must go back up, but why, and to what level? The 1970s - 1980's saw global interest rates spike up to rates never seen before and they've been drifting down ever since. For most of us alive today our awareness and experience of either paying or receiving interest didn't start until we were in our twenties which means that for most of us interest rates have "always" been considerable higher than they are currently. But, just because we paid 20% plus for our mortgage in the 1990s or received 9% on a term deposit in the early 2000s does not mean that history will repeat in the near future. It may, but it may not. Like it or not all the worlds money markets are intertwined and what happens overseas does affect us in New Zealand.

The Bank of England released a chart, which I now can't find, of interest rates going back to before biblical times. It shows the very, very long term average interest rate is about 4%. It's probably not surprising that there are plenty of historical records of interest rates. They've found records going back to 2000 BC! Perhaps 4% is what we should expect interest rates to go to? If the central banks could get inflation back up to the mid point of the 1%-3% band they tend to target then 4% would not be unreasonable but that doesn't look likely in the next year or two.

What Might Push Interest Rates Up?

We haven't seen any significant indications that interest rates are likely to rise in the near future. A big influence on interest rates is inflation, if that was to re-emerge that would push rates up but there doesn't appear to be much inflation or any likelihood of inflation. Since 2008 we have seen unprecedented increases in the global money supply that many pundits predicted would lead to rampant inflation, but that just hasn't happened. Except in asset prices. Consumer prices have been largely stagnant. But stock markets and property prices have boomed.

Rising Wages?

There is a factor that could push prices and so inflation up. If the labour markets forced up wages that could lead to increased costs and so increased prices and the additional money in the hands of consumers might increase spending. Unemployment in the US, UK, Australia and New Zealand is around 5%-6% which is very low. So a labour supply shortage on it's own might see increases in wages. The corporations wont want to see erosion in their profits so they might respond with higher prices. But there appears to be plenty of  fat in the profits of most international manufacturers, partly because of low interest rates. So the price rises might not eventuate, if they did would most likely be small or might be "one off" which wouldn't be inflationary. Then there is China, now a massive influence on both global supply and demand, they still have a massive work force prepared to make things, still relatively cheaply, will they just fill the gap?

Wage increases in New Zealand could stimulate inflation in New Zealand which would lead to higher interest rates. Do you see any signs of significant wage rises on the horizon?

Country Risk?

If international investors considered the New Zealand economy to be of higher risk than other countries that would lead to us being required to pay higher interest rates to borrow money. If anything the reverse is happening. New Zealand is generally regarded as a reasonably safe place to invest.

The Unknown?

But there is always the unknown, who knows what a massive meteorite strike in the Middle East, an earthquake in South America or Trump getting elected President of the USA will do? In fact probably very little in the long term.

So will interest rates go up again? Yes, probably, but they probably wont start rising for a couple of years yet and then gradually to perhaps around 4% in five or ten years time.

Do not expect to be getting interest rates above 5% from NZ banks in the near future, perhaps not in your lifetime.

But if you are seeking a higher return on your money than the banks are offering you must beware. There are many alternatives - some are sensible and worth considering, but others definitely are not. Do your research and make sure you are aware of all the additional risks you will be taking and what the potential pitfalls might be.

Did you know that at current prices the listed New Zealand companies: Hallenstein Glassons, Air New Zealand, Tower, Hellaby, Steel & Tube, PGG Wrightson and Genesis Energy are all offering a gross dividend yield of over 10%? There are many more companies paying over 8%. Maybe they'll continue to do so. Maybe they wont. Maybe they are too risky for you to invest in. Maybe the additional return is worth the risk.

So many maybes. If you'd like to understand why and discuss these and other investment options, you can ring Andrew or Jonathan on 07 578 3863.

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