Wholesale interest rates fell sharply last week, with the two-year swap rate falling 29 basis points on 14 December. Rates are now sitting at a nine-month low, adding downward pressure to retail interest rates. Lower mortgage rates could potentially stimulate economic activity when the battle against inflation is still being fought.

Wholesale rates are essentially interest rates at which banks and financial institutions lend to each other. Because wholesale rates determine the cost of borrowing for banks, they are an important influence on mortgage rates, with flow-on effects to the wider economy.

In this article, we explain the sudden decline in wholesale rates, and explore the potential economic implications heading into 2024.

Chart 1 shows that the two-year swap rate peaked at 5.8%pa in early October, and had eased to 5.1%pa by mid-December. On 14 December, the two-year rate dropped a massive 29 basis points to 4.8%, the largest single day fall for this rate since May 2023, when the Reserve Bank only increased the official cash rate (OCR) by 25 basis points and released a much more dovish statement than expected.

On the same day in mid-December, there were sharp drops in the one-year (down 19 basis points), three-year (28 bps), four-year (27 bps) and five-year (26 bps) swap rates. Rates have stabilised slightly over the past week, but they remain at their lowest levels since February 2023.

A substantially weaker-than-expected GDP result and surprisingly dovish signals from the US Federal Reserve drove the drastic fall in wholesale rates.

Stats NZ data released on 14 December showed a 0.3% decline in economic activity in the September quarter, well below market expectations of a 0.2% increase. The weak GDP result has encouraged the market to expect lower inflation and earlier cuts to the OCR. Because swap rates are closely tied to market sentiment, the mere expectation of interest rate relief drove wholesale rates down.

On the same day, the US Fed pencilled in at least three cuts to the Fed funds rate in 2024, taking a significantly more dovish tone than previously. This signal, coupled with the weak GDP figure, took financial markets by surprise and massively lifted market confidence, leading to the sudden slip in wholesale rates.

But the huge lift in market confidence is in sharp contrast to the Reserve Bank’s most recent Monetary Policy Statement. The Bank strongly affirmed in late November that interest rates might need to remain higher for longer, with a rate increase still possible in early 2024 and cuts as far away as mid-2025. However, financial markets now expect the OCR to be below 5.0% by mid-late 2024, and are pricing in these expected cuts with lower wholesale rates.

Falling swap rates were already beginning to have an effect on mortgage rates, even before last week’s sharp dip. In November, Westpac became the first major bank in New Zealand in several months to begin cutting mortgage rates.

Following last week’s shift, ANZ dropped its two-year fixed mortgage rate by 20 basis points, and its three-year fixed term rate by 14 basis points. BNZ has also cut its two-year and three-year rates.

This downward pressure on mortgage rates could exacerbate existing upside risks to inflation, by stimulating more household spending.

The Reserve Bank has previously expressed concerns about the potential for stronger demand from high migration and strengthening tourism, which are less sensitive to interest rate effects. The uptick in the housing market is also adding to inflationary pressures, with stronger housing demand boosting rental inflation and increasing risks of further construction cost increases. Increased shipping costs associated with disruptions in the Red Sea due to the Israel-Gaza conflict are also developing as another risk.

New Zealand’s battle against inflation is already fragile – non-tradable (domestically based) inflation has been stubborn, remaining above 6.0%pa for the last seven quarters.

Even before the sharp dip in swap rates, the Bank had revised up its forecast OCR peak to 5.7% in the September 2024 quarter, showing its willingness to raise rates further. At the time of this announcement, we believed that the Bank was “jawboning” markets (a form of bluffing, but with the ability to follow through) to ensure that financial markets didn’t prematurely price in interest rate cuts. However, the sudden decline in wholesale rates and the associated upside risks to inflation could cement another rate hike next year, and prolong the pains of above-target inflation.

Despite these risks, slowing economic momentum and easing capacity pressures could provide for a more optimistic outlook.

Subdued global growth, particularly from the slowing Chinese economy, has weighed on commodity prices and New Zealand’s export volumes. Easing commodity prices also reduces import costs, helping to bring down domestic prices. The NZ dollar’s recent strength could also add some downside to inflationary risks.

The Bank’s task is to assess the balance of sluggish global growth against potentially stronger domestic demand, and set interest rates accordingly; currently, there are several factors at play that could tip the scales in either direction.

Key data releases in early 2024 will include the NZIER’s latest Quarterly Survey of Business Opinion (published on 16 January), the December quarter Consumers Price Index (25 January), and December quarter Labour Market Statistics (7 February). The Reserve Bank’s Monetary Policy Statement on 28 February will help establish whether this newfound market expectation of rate cuts is overblown, or supported by real data. We will be keeping a close eye on wholesale rate movements in the mean-time.

We wish all our readers a merry Christmas and an enjoyable break over the holiday season.