Interest rate prospects appear positive, but risks will always be with us.
Economists, try as they may, don't always get future predictions right, and
many of us did not get the timing or the magnitude of the recent interest rate
up-cycle right either. In fact, the only certainty about the future is that it
is an uncertain place (apart from the obvious death and taxes). So how then,
should one think about interest rates and manage risk going forward?
Firstly, the Rand Merchant Bank forecast for interest rates is one of no further
increases during the current cycle. Interest rates are not expected to move
either way for the rest of the year, where-after a gradual reduction by the SARB
(Reserve Bank) from 2008 is expected.
WARNING: As mentioned above, there are ALWAYS risks to all forecasts. When
buying a home, make provision for some "upside risk" regardless of what the
general expectation around interest rates may be. Calculate some "what if"
scenarios on repayment values should rates rise another, say 1-2 percentage
points (for instance, will you need to boot mother-in-law out of the garden flat
to make way for a paying tenant in such a scenario? If so, should you not buy
slightly cheaper and have a little more money in reserve for such a possible
event?)
Indeed, in the near term it would appear that there is some "upside risk" to the
inflation and interest rate forecast, emanating from another spike in maize
prices, along with a mild rise in oil prices just recently. But we believe that
on the balance of things this need not scuttle the forecast. At its last
Monetary Policy Meeting, the SARB adjusted its own inflation forecast downward
and now believes that CPIX inflation will stay within the upper-target limit of
6%, so things look reasonably promising.
Many people focus on the short term prospects for interest rates despite the
fact that a home loan is repayed over a long period of up to 20 years. It is
very important to look well-beyond the next year, both at how rates may move, as
well as how your costs may change (are there 4 children on the way?). From a
long term interest rate perspective, the news also appears positive. Due to much
structural change in the economy, and an opening up to foreign competitive
pressure after the sanctions and boycott era, inflation today is far lower than
it was 20 years ago. I believe that South Africa's interest rates are still on
the high side, and that there is scope for further decline, given the long term
broad downward trend in local inflation. With sound macro-fiscal and monetary
policies in place, there is good reason for South Africa to converge to a large
extent with the low inflation rates of its major trading partner countries. Low
inflation is crucial to interest rate levels given that the Reserve Bank now has
an official CPIX inflation target of 3% to 6% (CPIX inflation currently hovers
at around 5%). One key longer term upside risk to inflation, and therefore
interest rates, over the next 5-10 years, emanates from the proliferation of
infrastructure projects needed for higher long term economic growth. High rates
of capital goods imports, necessary for many such projects, could put pressure
on the rand. The flipside of the coin is that improved economic growth potential
should raise South Africa's ability to attract foreign capital inflows thus
supporting the rand. So high rates of imports are a risk, but they need not
necessarily scuttle the inflation target.
One also needs to take a view on the magnitude and speed of future interest rate
moves (not an easy task) when planning for a long term loan. Further positive
news in this regard comes from the way the SARB has changed its approach to
interest rates, and this has clearly been reflected in the last round of
interest rate hiking. Some people with long memories still ask the question
"what if 1998 happens again?". In mid-1998, the SARB raised interest rates by
7.25 percentage points in less than two months, a killer blow to many indebted
households. Fortunately, the probability of such an event has been dramatically
reduced due to a change in policy. In the '90s, the SARB was tasked with
"protecting the internal and external value of the rand". This implied that, not
only was it expected to contain domestic inflationary pressure, but it was also
expected to intervene directly to stem the tide of rand weakening, which
happened all too frequently in those days. In mid-1998 we had a severe rand
shock. The SARB had very limited foreign exchange reserves which it could sell,
in order to buy rands and support the local currency's value. Therefore, it had
to resort to raising interest rates in a bid to attract the type of global
capital that looks for a return from relatively high interest rates. The SARB's
best efforts had limited success in curbing the rand weakening, but did a lot of
damage to the housing market. Since then, the Minister of Finance has formally
changed the brief of the SARB to one of CPIX inflation targeting i.e. the
protection of the internal value of the rand. Exogenous shocks such as a rand
weakening and oil price rises do have an influence on the CPIX inflation rate
due to their influence on the cost of imports. But the impacts are watered down
through the supply chain and the CPIX inflation rate is far less volatile than
the rand. The implication is that the SARB can afford to be far more moderate in
its interest rate moves because it is trying to influence a far less volatile
variable, and indeed this has been the case. In 2001, after a rand crash every
bit as bad as 1998, the Bank raised rates by a far more moderate 4 percentage
points over 9 months during 2002. Then, last year, the SARB's concerns over
rising inflationary pressures along with high growth in household borrowing and
a wide current account deficit, led it to raised interest rates once more. But
again, the move was extremely modest i.e. 2 percentage points over a period of 6
months.
'Never say never', but for reasons mentioned above, which include both official
policy changes plus an apparent desire by the SARB to be more transparent (it
runs scheduled interest rate meetings these days with post-meeting announcements
on television) and stable in-policy application, the probability of a 1998
happening again has been dramatically reduced.
All pretty positive news, with the normal caveats attached. Does this mean it is
time to abandon the search for the best fixed interest rates because 'happy
days' are probably on the way again? Not necessarily. While most people only
begin to consider fixed interest rates when interest rates start to rise, the
irony is that by that stage of the cycle it may be too late to get a decent
fixed rate. This is because fixed interest rates are largely linked to market
expectations for interest rates going forward. If banks provide a fixed rate
for, say, 12 months ahead, then in order to manage out their risk they will
hedge it in the forward market. The interest rates in the forward market are
determined largely by market expectations of what floating interest rates will
be (although this market, like economists, doesn't necessarily get it right).
When inflationary pressures are rising, and interest rates look like they are
rising as a result, the forward interest rate markets are very often pricing in
rate hikes and are significantly higher than the SARB's repo rate (to which
prime rate is linked). This is why many home owners looking to fix rates after
the first interest rate hikes last year were disappointed by the high fixed
interest rates that banks were generally offering. Given that the SARB is not
prone to moving rates rapidly and radically up or down these days, it seemed to
make little sense to fix interest rates at that stage, given what was on offer.
The time when one will possibly be offered more attractive fixed interest rates
on home loans is, perhaps ironically, when floating interest rates have started
declining, and the forward market is pricing in further cuts. Unfortunately, at
that stage many people seem to have lost interest in fixing rates because they
are hoping to capitalise on floating rates going lower.
In closing, therefore, whether you want to fix or float your rate depends on
your appetite for risk. But if you are keen on a good fixed interest rate on
your home loan, don't stop looking when interest rates look to be going down.
That, ironically, may be the best time to be on the lookout.
