ANZ economists believe interest rates will continue to nudge higher and this, coupled with tighter credit conditions, will keep the brakes on the housing market.

In ANZ's latest Property Focus publication the economists have estimated that mortgage costs on the average house for new purchasers in Auckland are chewing up about 51% of monthly income - and that's at a time of very low interest rates.

"That is on par with the highs reached in 2007 despite mortgage rates being near historic lows currently," chief economist Cameron Bagrie says.

"It highlights how sensitive some recent home-buyers in Auckland would be to even a small lift in interest rates."

And Bagrie says interest rates are going to keep nudging higher.

"It won’t be rapid, and it won’t be driven by the RBNZ, primarily."

A directional change in interest rates has three important implications, Bagrie says.

Firstly, increases in borrowing rates change the economics of the entire borrowing equation and can turn "affordability metrics" sharply, especially when the levels of debt are far larger.

"House prices have risen to such an extent that we estimate that for the average Auckland household to purchase the average house (at a 20% deposit, 25 year mortgage term and at the cheapest mortgage rate on offer), debt servicing costs (principle and interest) would now represent 51% of average disposable incomes.

"A 1 percentage point increase in mortgage rates would see this jump to nearly 56%, which is far higher than in 2007, when the minimum mortgage rate was closer to 9%!"

Secondly, Bagrie says higher interest rates get the market (buyers) thinking about where rates could be a couple of years down the track – "and that’s critical for market psychology".

And finally, higher rates force a shift to the fundamentals and more cash-flow based investing. "It needs to be more of a numbers game and less of a capital gain one. There are still strong expectations for capital gain though; 4.6% according to the ANZ Roy Morgan expected house price inflation measure."

Bagrie notes that the property market has cooled rapidly as the combination of loan-to-value ratio restrictions, higher interest rates (a turn in both the local and international cycles) and "credit rationing" dampen demand.

"That’s provided a near-term hit to recent exuberance, though it’s worth bearing in mind that a demand-supply mismatch will provide support and typically that’s seen the market run away again after previous similar lulls.

"What is different this time around is that interest rates are moving up and appear set to continue to do so, and policymakers are more serious in their desire to quell excessive lending growth. This will reduce the potential for the market to lift in a material fashion from here."

On the actions of policymakers, Bagrie says: "The RBNZ is undertaking a review of bank capital; if banks have to hold more capital that will put more upwards pressure on interest rates. Regulators on both sides of the Tasman are not standing idle; this will impact both the price and availability of credit as they eye curbing the credit accelerator model and leveraging behaviour (growing borrowing in excess of income growth), which are seen as a threat to financial stability."

Bagrie says that previously when the RBNZ has introduced loan-to-value ratio restrictions there has been a lull in housing market activity followed by a resurgence as interest rates have continued to fall.

"House prices can look semi-affordable at a house price to income ratio of 9.5 when interest rates are extremely low, but the key point is that it is not sustainable; the equation can change dramatically when interest rates nudge higher."

The key driver of the anticipated continuing rises in interest rates, Bagrie says will be the "the massive funding gap, which is forcing a change in bank’s behaviour".

"Deposit growth continues to trail credit growth. In household parlance, that’s more money going out the door than is coming in," Bagrie says.

"Banks can fill such a gap temporarily by borrowing offshore, but it would not be in New Zealand’s long-term interest to let such a gap persist. The current account deficit (and external debt levels) would blow out, New Zealand’s credit rating would likely get reviewed, and inflation would turn up if a spending boom were to join the housing equivalent, necessitating tighter monetary policy and a higher OCR. Credit-driven booms invariably end in a bust as the piper gets paid."

Bagrie says the banks' funding gap portends more pressure on deposit rates to lift and credit growth to slow, "which is precisely what we are seeing".

"...And on top of that we expect a gradual rising bias to international interest rates, which will impact longer-term rates here. Which is going to win out? Rising interest rates and diminished credit or a shortage of housing supply in the face of still-strong migration?

"The former will actually dampen the supply side response, making the supply-demand imbalance even starker. Witness all those stories in the paper about projects struggling to get finance – although a big reason for this is also an explosion in construction costs, which makes it even more difficult to get the deals to stack up (refer last month’s Property Focus). Economics 101 tells us prices will need to lift if an even larger shortage opens up.

"We’re backing interest rates and credit to dominate supply-demand imbalances, or at least buy some time for the latter to catch up. That seems to go against the aforementioned Economics 101 conclusion, but if the supply thesis was really all that’s driving property prices we wouldn’t have seen such a wedge open up between house prices and rents. The latter would have risen more sharply too. This doesn’t mean we discount supply tension. Such tension will still be apparent for a long time yet. We simply need to put it in context and think more broadly."