The Impact of Rising Interest Rates

The Reserve Bank’s recent increase of the Official Cash Rate (OCR), albeit a small one, heralds the start of a new cycle in interest rates. The outlook for New Zealand economic growth is good, thanks to construction in Christchurch and a buoyant export sector. As the economy grows, interest rates will continue to rise so as to avoid high inflation. This is good news for some people and not so good for others.

Investors sitting on large bank deposits have been waiting patiently for interest rates to rise and reflecting on the good old days when it was possible to secure a term deposit at 9%. While the OCR will gradually increase over the coming year, there is not a direct correlation between the OCR and bank deposit interest rates.

There are a number of factors working against an increase in deposit rates. Banks are already flush with funds and as lending rates increase, there will be less demand for bank loans. There will be less pressure on banks to pay more in interest to attract deposits. Banks also have other sources of funds and right now they can borrow more cheaply in wholesale markets or offshore than they can from retail investors.

Now is not the time to be investing in long dated bonds with a fixed coupon rate. As interest rates rise, the value of bonds falls. That’s because the coupon rate of interest on the bonds becomes less attractive as market interest rates rise and the bonds, if offered for sale, will sell only at a discount. Perpetual bonds with reviewable interest rates could well become more attractive in a rising interest rate environment.

Borrowers such as house owners and businesses should now consider fixing their interest rate or alternatively budgeting for a significant increase in debt repayments.