Comment: What will interest rates do in 2005?
12 January 2005
Comment: What will interest rates do in 2005?
The holiday season is the usual time to relax and ponder the prospects for the new year. Our views and prognostications have been developed with the same intellectual rigour as everyone else's – with a beer in one hand, fashion-challenged, trying to find some sun.
2005 will be unique in one respect – it is election year. That means that the fiscal influences on interest rates will be higher than usual, as the government spin on 'tight spending" inevitably gives way to the usual election bribes. Expect no less this time around. An election spend-up is designed to have an immediate 'positive' effect – done knowing full well the Reserve Bank will have to use monetary policy to mitigate the excesses. But the Reserve Bank's measures are slow to take hold – even more so these days – so an election spend-up will just raise the chances of a hard landing, well after the voting has been done.
There is, of course, plenty to spend-up. This government is taking $5 billion in tax more than it is spending, and lowering the burden on voters is not on their agenda at all. The 'dead weight cost of tax' – the inefficiency of the government spending it rather than the voters – will mean that growth will be less than it could be, and the RBNZ reaction will be more restrained than otherwise - (an odd case where inefficiency is a 'good' thing).
For every $1 billion of election promises, GDP will be pumped by about +0.6% and inflation pressed by about the same amount. It could be worth one or two OCR increases of 0.25%, taking the OCR to about 7%
Then there are the real world effects. The trade deficit is likely to breach 7% of GDP in 2005, the point where international investors get nervous. Housing pressures will subside, as immigration continues to tail off and Australia sucks up growing volumes of kiwi skills.
The exchange rate NZ$:US$ will come off rapidly as the year progresses. The principle reason will be the strong US economy, allowing the Fed to raise interest rates, and reducing the premium yields New Zealand offers. A 'neutral bias' in the US will be a Fed Funds rate of about 4%, up about 2% from here. In contrast, we expect the NZ OCR to rise only about another 0.5%, and that will happen only later in the year.
A falling exchange rate will unhinge the international 'hot money' chasing yield, so expect a net outflow as these mature, putting substantial pressure on the exchange rate. The faster the fx rate falls, the more inflationary it will be, the harder the RBNZ will react - a hard landing scenario.
Exports will be helped by the lower fx rate. We expect commodity prices to stay high through 2005, given the strong US economy, and this will drive China, Australia, and possibly Japan. Good commodity prices and a falling exchange rate will make the rural sector very buoyant. And that will underpin some real growth. We agree with other commentators that we should expect growth in the 2-3% range, but there will be a shift of prosperity to rural from urban.
A falling exchange rate will also mean that cheap international bond funds will no longer be available to finance fixed-rate mortgages, especially those 2+ years, as there has been over the past year. Expect all mortgage rates to rise significantly. For those who took the 2 year fixed option in 2004, the effect will be minor; for those on shorter terms including floating rates, and those who fixed in 2003 and earlier, there will be a nasty surprise ahead. As the year goes on, housing will move off the radar as a superior investment prospect.
We expect the election to be at its normal time, due in September 2005. It will be the Labour government's to lose, and it is hard to see the cold bite of the inevitable changes that will gather momentum in 2005 undercutting their current substantial lead. It is our view that a lot of the prosperity that we have enjoyed in the past 4-5 years is due to the investment in good public policy made in the 1990's.
The recent gradual unstitching of those reforms, the very rapid growth in public sector costs, and rising levels of taxation, will be something an unlucky future government will have to deal with. Some positive changes that have been made in the past few years will survive, but they are dwarfed by the huge run-up in public sector consumption, especially in health and the operating costs of education.
Investors should be moving their portfolios to investments that will benefit from the coming fall in the exchange rate. Investments exposed to returns generated outside New Zealand include shares, currency, and NZ companies who generate substantial international earnings.
Exposure to the rural sector won't hurt, either. De-emphasise NZ property, and NZ retail such as consumer credit. Yields from fixed interest bonds and debenture securities will rise markedly. There will be real pressure on some finance companies as consumer credit demand slows, and their cost of funds rise.
Borrowers will need to convert maturing fixed-rate mortgages to shorter terms, 6mth and 1 year, as rates for terms two years and longer rapidly rise in response to rising international bond yields, pushed by good growth in the US and China, and the Fed Funds rate settling at or just above 4%. The above is just opinion, of course. I see the sun has come out. Time for another one.
David Chaston is a commentator on New Zealand interest rates, and watches them through his on-line service www.interest.co.nz