Interest rates, inflation and property investor regulation in 2015

Interest rates are likely to remain at current levels throughout 2015, and any increase after that is likely to be slow. That’s the key message from the latest Reserve Bank interest announcement which left the Overnight Cash Rate (OCR) unchanged at 3.5%. That basically removes a significant risk factor for property investors, at least in the near future.

According to the Bank’s Monetary Policy Statement, interest rate increases are likely to be modest – less than 1% over the next three years. Earlier the Bank had predicted rises by the end of this year. There are two reasons for the change of view.

Crude oil prices are at their lowest level in five years. The simple fact is the world is now less dependent on oil from the 12 OPEC countries – it is losing its monopolistic influence over price. As detailed in Property Plus recently, the emergence of the USA as the world’s largest oil producer has changed the market pricing to one driven by demand and supply. Improvements in extraction technology have opened up new oil reserves and once again shown how innovation creates solutions unimaginable to those who warn of resource depletion. Lower crude oil prices are already benefiting motorists at the petrol pump and the benefits will soon flow through to lower freight costs and airfares.

Lower fuel costs will make the Reserve Bank much more confident that inflation will remain within its target range – inflation is not going to be a concern in 2015.

The second factor slowing down interest rates is the hit the economy will take because of a lower dairy payout. Last week Fonterra again reduced its forecast payout for the 2014/2015 season, this time by 60 cents to $4.70 per kg of milksolids (which is down $3.70 on last years record payout of $8.40).

The lower payout means a loss of farmer incomes of about $6.8 billion according to Dairy NZ figures. Given the average herd produces about 139,000kg milk solids, the average dairy farmer will be $500,000 worse off!  In Northland the total income loss will be $378m. That’s significant.

The lower payout follows a collapse in international dairy prices, down some 50% since the start of the year. If that were a share market index the media would be headlining a market crash! To make matters worse, the dairy sector is heavily geared. On average, sheep and beef farmers have 77% equity in their farm, but and dairy farmers have only 58%. Twenty percent of farmers have 50% of the industry’s debt!

At $4.70 rural commentators believe a quarter of farmers will struggle to pay their bills, and the 20% that have most of the debt will not be able to survive without the support of their bankers – they will be insolvent.

While farmers and the rural lending sector may be able to manage one season of low prices, the industry will be in serious trouble should that extend to two or three seasons.

Westpac is forecasting a payout of $6.20 for the 2015/16 season, but that assumes global milk prices will rise rapidly in 2015. Ominously, the NZX Dairy Futures market indicates whole milk powder will not exceed US$3,000 per tonne at all during 2015, and at the 2 December global auction the price declined 7.1% to US$2,229. The next dairy auction is on 16 December.

In my view it is wishful thinking to expect a rapid rise in dairy prices. Having experienced a number of investment market crashes in the last few decades, the general trend is that it takes some time for prices to recover. I think that is a more realistic scenario than one that assumes a rapid recovery.

The loss of farming income will be serious for the provinces, but have little or no effect in Auckland, Wellington, and Christchurch. That will widen the economic divide between those cities and the rest of New Zealand and create a policy dilemma for politicians and the Reserve Bank: How do you revive economic activity in the provinces but control a rampant property investment market in Auckland? Some say it should be through immigration controls but it is more likely to be via lending regulations targeted to large (+5) residential property investors. That will most likely to be the focus of the Reserve Bank early next year.

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