Time to prepare for higher interest rates?

In May, the Reserve Bank of New Zealand (RBNZ) released its updated forecast for the Official Cash Rate (OCR) showing rate hikes beginning in the second half of next year. Since then inflation data has come in above their 2% target at 3.3% and the unemployment rate has declined from 5.3% in September last year to 4%, its lowest level since before the GFC. With these two key economic indicators hitting the Reserve Bank’s targets the focus now turns to whether the economy is running too hot or not.

The RBNZ implements monetary policy by setting the OCR, influencing short term interest and mortgage rates. In a booming economy, the RBNZ may raise interest rates to encourage people to save more and spend less, which should slow economic activity. On the other hand, it should cut interest rates in an economic downturn to stimulate the economy by encouraging people to borrow and spend. This happened in March last year when the RBNZ cut the OCR to a historic low of 0.25% in response to the Covid-19 crisis.

Subsequently, the New Zealand economy has fared much better than many had feared as illustrated by a low unemployment rate. The decision to cut the OCR has undoubtedly contributed to New Zealand’s swift economic recovery. However, given the strength of the economy today, the same monetary policy put in place for the pandemic is arguably no longer necessary.

The below chart shows the market expectations of the OCR over the next couple of years, slowly rising to a more ‘normal’ 2%. It also reflects an expectation from markets that the RBNZ will raise the OCR sooner than previously forcasted, given the latest inflation and employment data.

Managing risks and opportunities

One of the most significant impacts of rising short-term interest rates is likely to be on the housing market. In the last year, house prices are up a staggering 30%, but higher interest rates lead to higher mortgages rates, and that will likely reduce demand and slow house price growth to a more sustainable level. With this in mind, we recently reduced our NZ share funds’ exposure to retirement village operators such as Ryman Healthcare and Summerset Group. These companies are essentially owners of large property portfolios, so less house price growth translates to less profit.

To provide some protection against rising short term interest rates, our funds have had a lower allocation to fixed interest than ‘normal’. However, as shown in the chart above, the market is already reflecting future OCR hikes, so we have slowly been repurchasing these bonds at more attractive (higher) rates.

Disclaimer: This article has been prepared for the purpose of providing general information, without taking into consideration any particular investor’s objectives, financial situation or needs. Any opinions contained in it are held by the author as at the report date and are subject to change without notice.