By Roger J Kerr
Complacency about interest rate risk for borrowers is understandable after eight years of a very low and stable rate environment.
There have been too many false starts of interest rates increasing over this time to dissuade such borrowers out of that complacency.
The RBNZ’s current monetary policy stance to not think about lifting the OCR until actual inflation is above 2.00% (and confirmed above 2.00%) for some time also has a whiff of complacency about it.
However, given all the false starts on inflation increasing over recent years (only to fall back again for various reasons), the complacency may be defended.
Pre-emptive action is a central tenet of risk managing financial market variables such as interest rates.
Moving early with hedging action and averaging-in progressively to the desired level of fixing is always a lot easier to manage than being forced into big decisions because the market is suddenly moving against you.
The trade-off with these interest rate hedging strategies is always “how much extra interest cost am I prepared to pay today for the security and reduced volatility of interest cost in the future?”
Borrowers who have continuously extended their fixed rate swap books in term through the last five years are now starting to see the benefits of their consistent strategy as longer-term interest rates increase.
Whilst there may not be risks associated with 90-day to two-year swap interest rates increasing for the next 12 to 15 months (first OCR lift from the RBNZ mid-2019), borrowers who wait may find the term swaps rates up to 0.50% to 1.00% higher in 12 months’ time when they finally decide the risk is with them.
Paying 0.50% more over five years is not good economics against paying away 0.70% over the next 12 months (the difference between 90-day floating rates and term swap rates).
The risk that our three to 10-year swap rates suffer a “double-whammy” increase of US 10-year Treasury Bond yields moving above 3.00% and the NZ:US bond spread reversing from its eight basis point low point is a very real one indeed.
Borrowers need to be considering these risks in the separate and independent long-term interest rate market and implementing hedging strategies accordingly.
The incoming RBNZ Governor, Adrian Orr would be expected to lean towards pre-empting inflationary pressures getting out of the bag, than merely waiting for the higher inflation to arrive and then it is too late to do anything about it.
The local financial markets will be looking very closely for any slight change in wording or innuendo from the RBNZ on this aspect once the new Governor is in the chair.
Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com