In part one we discussed: the Official Cash Rate (OCR) and how is it applied; inflation and why is it important; and the connection between interest rates and inflation. Here we’ll cover forward interest rates and how they are calculated and current inflationary drivers in NZ. I’ll then pull these five factors together to argue why I wouldn’t fix for 12 months.

What Determines Forward Interest Rates?

Forward interest rates can most simply be described as the market sentiment of where interest rates are headed in the future. Interest rates are influenced by the OCR and the OCR is influenced by inflation. Therefore, forward interest rates are reflective of future inflation. If we believe inflation is going to be high (and the OCR and interest rates raised) we would see the forward yield curve slope steeply upwards, and vice-versa.

The market is currently forecasting a small rate cut in the OCR with monetary policy expectations (as of September 3) forecasting an OCR rate of 1.65% as at September 26. Overall, we are seeing a flat yield curve (the market spread on interest rates is small: 1.30% over five years per ASB special rates September 3).

Current Inflationary Drivers

There is currently significant wage inflation in NZ. You don’t need to look beyond the six o’clock news for this, with strikes and minimum wage increases. These lifts in wages may also prompt other wage hikes as people try to maintain their income differential. Wage inflation leads to further “discretionary” income available for people to spend and as we know more spending equals higher inflation. It will also lead to further costs for businesses (a higher wage bill) and therefore likely an increase to the cost of the goods they sell to offset this.

Fuel Tax

The most recent increase in fuel tax will directly impact on the cost of products for businesses. Fuel is a key component to the underlying cost of goods. Most businesses will seek to push this expense back onto the consumer through a higher cost of products and services.

House Prices

There remains a large demand in the construction sector, underpinned by public projects, which is maintaining construction costs. This, along with KiwiBuild, will set a floor on house prices.

Despite this there is a softening in national house prices as lending restrictions begin to take hold and capital gains slow/ cease. This could see funds spent or invested elsewhere which will bolster inflationary pressures.

NZ Dollar

The NZ dollar has been falling against other currencies (most notably the US, it has fallen from 74c in April 2018 to 66c today). This will result in the cost of imported goods increasing and exported goods decreasing for the overseas buyer. The increase in cost of goods will naturally flow through to prices. The decrease in cost of exports may see demand for NZ goods increase overseas (as they become cheaper for foreigners). This leads to more cash flow for exporters and therefore more discretionary income.

Where Does That Leave Us?

I suspect that the above will lead to increased inflation. Currently inflation is running at about 1.7%. By mid-2019 inflation might be pushing 2.5-3.0%. There is a global trend, led by the US, of increased interest rates. The US has lifted interest rates seven times since December 2015 and will continue to do so until they reach 3%+.

History has shown thats the US’s OCR equivalent needs to be cut 3% on average to spur the economy out of a recession; it is currently at 2%. This has an effect on the NZ economy. Together with the inflationary pressures coming through, may lead to an increase in the OCR. It may also lead to an upward lift in the forward yield curve. What does this mean?

In 12 months’ time I would expect the yield curve to be trending upwards, meaning forward interest rates will be higher. It won’t be easy to renegotiate interest rates in that environment.

Twelve-month rates are attractive now, but they may not be in 12 months. Perhaps look at splitting your portfolio over different periods, giving yourself protection by fixing out for a longer term.