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Interest Comment: Yields for depositors look up

Comment: Yields for depositors look up
David Chaston

When Dr Bollard raised the OCR to the giddy heights of 6.75% last week, all eyes turned to the inevitable mortgage rate announcements.

Westpac was the first out of the blocks, raising its variable rate to 9.05% and all the others are expected to follow over the next week or so.

Fixed mortgage rates are also expected to trend up, not so much as a reaction to the RBNZ move, more as a direct reaction to rising international bond yields.

But this month we want to consider where deposit rates will go. They should go up as well, right? Yes, well sort of – it depends!

The first point to make is that deposit rates are not so directly affected by outside forces such as the RBNZ's OCR or the cost of international bonds. Deposit rates react solely to local market pressures – the old supply/demand tension.

Banks and finance companies are essentially lenders – they make their money by lending. No one makes money by taking in deposits – that costs them money. They only borrow from depositors to feed their lending business.

But they have a choice about where they source their funds – from the wholesale markets, or from retail depositors.

Wholesale supply is efficient. It is a bulk source. But it does come with a major disadvantage. Wholesale suppliers are demanding lenders. They impose strict rules, they require extensive information, and they can be fickle – their reinvestment appetite is never certain. And, sometimes they are not as inexpensive as their customer wants them to be because they benchmark their returns against the best they can get elsewhere.

Banks and finance companies like to get retail deposits. They are more stable, they don't respond to market pressures as aggressively, and they help build customer and brand loyalties. But they do require a lot of work – advertising, disclosures and legal requirements, and administration.

The cost of retail deposits depends on two things – whether the funds are required for lending and liquidity-management reasons, and/or the price competitors are paying.

There are a lot of deposit funds around. Our comprehensive review of the total bank and finance company sector shows that unsecured deposits (mainly bank deposits) grew by +11% between 2003 and 2004 to about $165 billion, and secured debentures (mainly in finance companies) grew by +21% over the same period to $9.1 billion. Part of this is growth from increasing prosperity, and part because funds are shifting in from out-of-fashion mutual funds.

While the fixed-interest deposit market is flush with funds, the demand for those funds from the lenders has been strong also.

However, it is a misconception to expect rates to rise solely because of an OCR rise or hot demand from the driving real-estate, consumer credit, or development markets.

In fact, rates offered to investors have trailed those factors, mainly because of the surplus of funds available.

This has led the New Zealand market to feature rate premiums that are low for the risks involved in the underlying businesses in which a depositor's funds are invested.

The base or benchmark term deposit rates offered in New Zealand are bank rates. There is some variation between institutions, but generally what is offered is in a tight range, usually plus or minus less than 25bps (100 basis points = 1%).

For terms less than 1 year, finance companies offer little advantage, with one curious exception.

But for terms, one year and over, there are significant yield advantages by choosing a finance company over a bank. Their yield advantage has been increasing, and ranges from better than 100 bps at 1 year to almost 180pbs for a 5 year deposit. And, remember, these are averages. Yields from some specific finance companies are much greater than this.

But yield is not everything. Risk is an equally vital element that must be considered as well. Our advice is to start your assessment of risk by making a short list of potential deposit opportunities by using the SQP Score©.

Demand for deposit funds has been increasing, but will this continue?

Because the economy is going well, demand for the funds that support consumer credit have been strong. And, while building consents issued have been rising, building work completed has levelled off. This means there is an increasing backlog and along with the skills shortage, demand from this sector should be strong for some time yet. It is in the mortgage sector we may see lessening demand sooner with the first signs of lower sales levels and longer days-to-sell.

Overall, we expect for 2005 to maintain a high level of demand for deposit funds.

In the last week or so, we have seen banks up their appetite for deposits. ANZ is offering 6.70% as a one-year special, HSBC is doing this rate on standard terms. Every bank has raised their 1-year-and-over rates recently. They all need to be there or higher because Superbank now offers 6.70% at call, so we expect bank rates to rise further.

To maintain their risk premium, finance companies are also increasing their rates. They are under pressure because they are not getting the level of funds they need for their regular operations. While this is not currently serious, it is constraining. We expect to see intensified competition for depositors from finance companies in the next few months.

Some finance companies have raised their 1 to 5 year rates up to a tad under 10%, and we expect the 10% barrier to be broken quite soon by a number of the smaller ones, and the 9% barrier pushed by even some of the larger and more well-established brands.

By the third quarter of 2005, don't be surprised to see high 9% rates being offered by those same well-established names, with the rest of the market even higher.

It seems that the tide is turning in the depositors favour, even if it is only for the remaining months of 2005.

Longer prospects are harder to forecast. It very much depends on your view of where the economy will be in 2006. The recent OCR rises suggest the RBNZ is choosing to fight inflation at the risk of a 'hard landing'. Dr Bollard himself has acknowledged the preference.

Deposit rates currently give little premium for term – the 1 year rates are very similar to the 5 year option. The yield curve here is very flat.

We don't see that changing much in 2005. There is, however, the real prospect that 2006 will be soft. It is unlikely the RBNZ will raise the OCR much more than once more, and then hold or reduce. The US Fed is likely to keep raising its rate from the current 2.5% all the way up to the mid 4% range, thereby removing much of the yield advantage NZ has, and undercutting yield as a factor for a strong NZ$.

That suggests the currency will fall, on the back of a slowing local economy in 2005/6, declining yield advantages, a growing current account deficit, and massive Eurobond maturities.

These factors will take the steam out of the 'demand' for funds, and limit how long high deposit rates can be offered.

We believe depositors should consider locking in 2-4 year rates when good finance companies start offering rates in the 9% range, as we cannot see it getting much better than that.

But choose your non-bank institutions carefully. Use our SQP Score© to make a short-list, and seek the advice of a professional financial adviser to focus that list on your personal investment criteria and risk appetite. Read and understand the information offered in the Prospectus before you make those final choices.

The above is just opinion, of course. You are encouraged to review the facts and form your own conclusions.

Note for editors:
David Chaston is a commentator on New Zealand interest rates, and watches them through his on-line service

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