Markets getting ahead of themselves on interest rate hikes

Financial markets have gone on a bit of a tear recently, shifting from one extreme to the other and now seeing interest rate hikes coming sooner and stronger than either the Reserve Bank’s or economists’ expectations. Such a shift is without proper regard for current economic conditions, future expected conditions, or the likely pathway for Reserve Bank policy. Instead, having got overly excited about bringing interest rates down, markets have now become overly excited about rates rising again.

Wholesale interest rates have been rising since mid-to-late October. Swaps for 2-10 year periods had increased 15-23 basis points (bps) between the low point in mid-October and 25 November, before the Reserve Bank’s November Monetary Policy Statement (MPS).

Come the MPS on 26 November, and swaps closed 7-11bps higher from the day earlier, and by the end of November were 15-30bps higher than before the MPS. By 12 December, 2-10 year swaps were 40-50 basis points higher than before the MPS (see Chart 1).

An increase of 50bps is a lot – it’s half a percentage point in less than a month. Importantly, it was mostly a New Zealand story. Although 10-year government bond rates had increased both in the US and New Zealand, the rise domestically was more pronounced.

With such a material increase in funding costs for retail banks, it’s unsurprising to see a lift in longer-term retail mortgage rates. But it took some time for banks to lift retail rates, suggesting analysts were questioning how sustained these wholesale rates rises might be. Westpac was first to lift, but effectively waited two weeks before making changes, dropping its six-month mortgage rate, holding the 12 and 18-month rates unchanged, and lifting 2-5 year rates by around 30bps. It took more than a week for most other banks to follow suit.

But why are markets now so strongly of the view that interest rates will rise soon and fast? There has been much talk of “missteps” by the Reserve Bank in its November MPS, that with such an apparently overt “hawkish” statement that of course the markets would start to quickly price in interest rate rises.

We find that view a bit over the top. The Reserve Bank played the November MPS with a straight bat. Too strong of a view of the potential for a further cut would undermine the ability of the incoming Governor to make a fresh call in February. And most importantly, based on the Bank’s views of the economy, it would be improper to tease the market about an interest rate cut when the Bank saw a limited probability of cutting again.

If cutting the official cash rate (OCR) below 3% was the stimulus the economy needed to jolt things into action, then it followed that once the economy was jumpstarted, that stimulus needed to be withdrawn and the OCR would need to rise back towards neutral. Our forecasts are for this lift to occur in late 2026 to early 2027. And for months now we’ve been highlighting our concern that, given the usual lags in monetary policy, recent cuts might have been overzealous. The Reserve Bank could be forced to hike the OCR in 2027 past 3% to limit any stronger and sustained pick-up in activity that threatens to send inflation higher.

Somehow, markets have taken the Bank’s November MPS as a signal to pick the quickest path to a rates hike – despite there being no strong economic reason for such a shift. The speed and intensity with which markets have moved suggests a very narrow view of the future rates path, and that expectations have become disconnected from likely outcomes in 2026. When interest rates were falling, all the market could see was the path down. Now that expectations have shifted to interest rates remaining on hold, all markets can see is that there is no probable cut to focus on, so it is time to pivot and target a rise. All the market can see is up.

Before the November MPS, markets had around a 50% expectation that the OCR would be cut down to 2.0% by May 2026, with expectations that the OCR would be lifted back to 2.5% by the end of 2026.

A day or two after the November MPS, markets had shifted to just an 8% chance of a further cut to 2.0%, and they were shifting towards earlier hikes. By 12 December, OCR market pricing implied that there was roughly a 90% expectation that the OCR would be back around 2.5% by July 2026 – nearly half a year earlier – and that the OCR would be back around 3% by the start of 2027.

These movements saw a statement that is unprecedented, at least in recent times, from the new Reserve Bank Governor Dr Anna Breman. In the statement, the Governor “reiterated that the forward path for the OCR published in the November MPS indicates a slight probability of another rate cut in the near term. However, if economic conditions evolve as expected the OCR is likely to remain at its current level of 2.25 per cent for some time” and that “Financial market conditions have tightened since the November decision, beyond what is implied by our central projection for the OCR.”

The Reserve Bank Governor’s unscheduled comments, issued publicly by the Bank and reiterated in media interviews, brought swap rates back down, but only a bit, with a 40% chance of the OCR being hiked to 2.5% by July 2026.

We like the style of the new Governor – calling it how she sees it, publicly and quickly. Markets are on notice that they’ve gone over the top, but they are still resisting the Reserve Bank’s view. That’s an interesting space to be in. The Reserve Bank could push back further in early 2026, but that would require a strong threat of a further cut – something that seems unlikely to be followed through on given current trends in economic data. So it might well be that markets maintain their strong position, prematurely pricing in future interest rate rises.

However, the sharp change in interest rate expectations has created understandable confusion for borrowers, particularly as retail interest rates for longer terms have risen even as the OCR has fallen.

Despite the reasons that we think the markets are out of kilter, rising rates could risk slowing the economic recovery. If interest rates rise further, all else being equal, household and business spending and investment might be more muted than the Reserve Bank assumed previously.

That risk around the economic recovery would put the Reserve Bank in a bind. Do nothing and the tightening already underway might undermine the recovery. Do something would require a cut, or a strong and credible threat of a cut. The latter approach would then have to be reversed out at some stage anyway – which could result in a similar stand-off between the Bank and markets that we are seeing now. For the moment, it might well be best to stick to the “we’re paused for the moment” line, pressure the markets to come back in line, and hope that such a balancing act is successful.