Interest rates and property prices

There are some pretty seismic things happening in the finance markets at present. Last week the Reserve Bank lowered the Official Cash Rate (OCR) by 0.25% and signalled further reductions are possible (the reviews are six-weekly).

My translation of the smoke signals is that things are getting pretty dire in the farming sector. Within 12 months farmers’ top line revenue has halved. That’s a collapse in anyone’s language. This would be manageable if it were a mere blip but price collapses rarely are, and it’s now looking like international dairy prices may remain low into the medium term.

The fact that Fonterra has announced it will go through a “review and restructure” supports the view  that recovery will take longer than expected. Fonterra has other issues. In the long-term the establishment of Chinese owned milk processing plants here in NZ may threaten their share of the supply chain; farmers get as much or more for their milk and they don’t need to tie up capital in Fonterra shares which could be sold to repay debt.

To protect farmer incomes and protect the economy from a shock, the people with their hands on the levers want a lower exchange rate so exporters receive more Kiwi dollars when they convert their now depreciated export earnings.

To do that they not only have to talk down the value of the Kiwi (which has not really worked to date) but make it less attractive for overseas investors putting money into our money market – hence reducing the OCR.

The 0.25% reduction on the 11th of June, and the commentary that further cuts are possible, had an immediate and desired effect. The Kiwi dollar fell by some 2 cents against the US dollar to just under 70 cents. Most experts expect it to go lower.

The major banks responded immediately by reducing floating mortgage rates (and deposit rates). The obvious risk is that it makes property investment more attractive, exacerbating an already hot Auckland property market – which the Reserve Bank claims is a risk to the economy as a whole.

This explains the policies in Budget 2015 to tighten the rules around the ‘intention’ test, and the move by the Reserve Bank two weeks earlier to make lending more restrictive in Auckland and less restrictive in the provinces.

How Auckland property prices react is debatable. My take on it is that prices will probably keep rising for a year or two then top out and flatten for quite a while. Supply is now catching up quickly and will turn into an over-supply.

Property investors see these trends long before the media report them so more are now buying in the provinces. Those cities within reasonably close proximity to Auckland are already seeing an investment migration: Hamilton, Tauranga, and Mount Maunganui in particular.

The provinces still offer rental yields greater than the mortgage interest rate. This is a pretty unique situation that usually does not persist for more than a few years. The latest mortgage rate cut has made the equation even more attractive.

The downside of a lower Kiwi dollar is that all imported goods and services (which are paid for in an overseas currency) become more expensive. About 30% of all goods and services (GDP) in New Zealand are imported. That makes us one of the most open economies in the world and vulnerable to exchange rate movements. The most obvious is petrol – the pump price may well be 10 to 20 cents a litre higher sometime soon. Ironically a lower Kiwi dollar will also inflate the cost of building materials, just at a time when the government is trying to make housing more affordable.

The bottom line is the farm and forestry sectors will get some partial relief from their crisis, living costs will increase for everyone, savers will get less from their savings, borrowers will pay less in interest (which they should put into additional principal repayments), those selling goods and services overseas will earn more, the number of overseas tourists is likely to grow, and provincial property prices are likely to rise.

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