The interest rate markets may take a few days to assimilate what the dramatic Christchurch earthquake means for that regional economy, businesses, local government and central government. I extend our thoughts and moral support to our numerous Christchurch clients who have to deal with the reality of the disaster. It may be insensitive and callous to talk of financial market ramifications when Christchurch households and businesses have been so badly shocked and disrupted. However, natural disasters do occur and thankfully New Zealand is well organised and prepared to handle the financial and economic consequences.

The New Zealand Earthquake Commission (“EQC”) has $5.6 billion invested in their Natural Disaster Fund to cover claims of property damage in an earthquake. The EQC investment fund is 30% weighted to overseas shares as an asset class, as it makes no sense (from a  risk management perspective) to have all your money invested in the currency of the economy where the natural disaster could be negative economically and force that currency value lower. The balance of the fund is invested in NZ Government bonds, and the EQC will be starting a process to liquidate part of that bond portfolio to have the cash ready to meet claims.

So far 4700 claims have been lodged at a maximum payout from the EQC of $100,000 per claim. Therefore approximately $500 million needed so far. Insurance companies with claims on top of this will also be well prepared with cash and liquid securities available to meet the avalanche of claims. The EQC will be working with the NZ Debt Management Office (part of the Treasury government department) to structure a plan to sell the bonds in an orderly fashion so as to not disrupt the market and force yields higher. Certainly, offshore and local bond traders/investors will be aware of this requirement to sell bonds into the marketplace. Increases in long-term interest rates seem inevitable in this situation. The $500 million estimate is likely to increase substantially over coming days/weeks.

The total cost of the repair and re-build of property and infrastructure is estimated at $2 billion, thus it seems that central Government will have to contribute funds at a time when it is increasing its own debt levels to fund fiscal deficits. Christchurch City Council, Selwyn District Council and Waimakariri District Council will also have increased debt loads going forward as a result.
The rally down in US Treasury Bond yields over the past few months has really lowered the funding cost of recent NZ Government Bond issues.

Our long-term interest rates are highly correlated to the US bond market. However the good times appear to be over with the less than expected decline on US Non-Farm Payrolls for August on Friday night (-54,000 compared to prior forecast of -100,000) adding to the improved US economic data in recent weeks. US 10-year Treasury Bond yields jumped up 20 basis points to 2.70%. The NZ 10-year swap rates hit a low of 4.75% last week; however they have reversed already to 5.00% and seem destined to move higher over coming days.

Time for the RBNZ to display courage of their convictions
Intestinal fortitude is what the RBNZ and its Governor need right now so that they are not swayed and overly influenced by the short-term/very changeable views of market economists who are calling for a “cup of tea” pause on removing the emergency monetary stimulus. The RBNZ will struggle to justify a material change to their 2011 economic forecast (from what they said in June) that warrants a fundamental change to their well sign-posted path of returning monetary settings to “normal”. In the Monetary Policy Statement next Thursday Governor Alan Bollard has an important PR challenge to educate the media and public that a 0.25% increase in the OCR from 3.00% to 3.25% will have absolutely no impact on the economy, mortgage interest rates and spending/borrowing/investing decisions in the economy.

The official interest rates have been out of step (well below) the true cost of money for many months now. All the banks have been paying 4.50% to 5.00% for their funding from retail depositors and offshore wholesale debt issues. A higher OCR to 3.25%, or even 4.50%, makes not one scrap of difference to where the real price of money (interest rates) has been trading between investors and borrowers for a long time already.

If Mr Bollard fails to clearly explain this unique situation he is allowing and fostering miss-information and misunderstanding in the marketplace. It is part of his job spec to communicate economic and financial market realities to the masses. He has to succinctly explain to all and sundry that lifting the OCR to 3.25% is not a monetary policy tightening in any shape or form. In my view, Alan Bollard would cause more confusion by taking a pause on the OCR, than sticking to his guns and original plan of removing the no longer needed monetary stimulus.

We saw in Australia last week how wrong the economists and moneymarkets can be on reading the strength of the economy. I am not saying the NZ economy will expand by 1.2% in the June quarter (we forecast +0.5%), however our economic recovery is not stalling as the economists and moneymarket pricing is suggesting. The long-term interest rates bottomed last week, the shorter term one to three year rates have seen their lows as well.