Roger Kerr posted on February 07, 2011 14:56
The New Zealand interest rate yield curve is going to get steeper in slope over coming months (long term rates up, short-term rates stable) before we see any other change to its shape.
The more steeply sloping curve will come from higher US Treasury Bond yields pulling up NZ long term bond and swap yields. The historical correlation between NZ and US long term interest rates is very high and unlikely to fundamentally breakdown anytime soon. It is however fair to say that recent increases in US 10-year T/Bond yields from 3.00% to 3.64% have not been matched by 64 basis point increases in NZ 10-year bond and swap rates. One reason for this temporary breakdown in correlation is the strong demand for new issue NZ Government bonds (at the weekly tenders) from Middle Eastern and Asian investors (e.g. sovereign wealth funds). These investors have been seeking to diversify some of their bond fund weightings away from US and European bonds to smaller markets like ours.
Another factor causing the somewhat surprising rally downwards in NZ 10-year swaps rates from 5.50% to 5.35%, over a period where US bond yields have increased, has been the unwinding of speculative yield curve spread trades. Offshore investment banks previously held open curve trade positions anticipating the yield curve to steepen (i.e. bought the short-end, sold the long-end). To unwind or close-down these market positions they have been forced to buy the 10-year swaps – forcing the yields lower in always thin markets.
I do not expect the drift lower in our 10 year swap rates to continue, despite the further delays in when the RBNZ will increase the OCR this year. If global bond investors are shortening the duration of their portfolios because US long-term bond yields are rising and positioned to rise a lot further, it is hard to see them buying our long term bonds or being investors in our 10-year swaps. There is little current demand on the pay side of the long-term swaps market as corporate borrowers are already highly fixed and set, or those that are not highly fixed do not see fixing rates at 5.50% as an economic hedge against a likely future “monetary policy neutral” 5.00% OCR/90-day BKBM. However, I do expect our 10-year swap rates to reverse back up and catch up to the increase in the US long term rates.
The investment world has moved from expectations of deflation to rising inflation in the space of the last six months. I never bought into the deflation maxim because Asia bounced back very quickly from the GFC and the US economy was always going to respond to massive monetary stimulation at some point. The US economic data coming out continues to improve and the latest lift in US bond yields to 3.64% reflects the bond market pricing- in higher future growth and higher future inflation.
Those corporate borrowers waiting for the yield curve to flatten by short-term swap rates (one to three years) increasing on OCR increases, to generate lower forward-start swap rates to extend existing swaps, have to recognise the risk that the lower forward start swap rates may not eventuate at all if the long-term yields continue to increase i.e. parallel shift higher in the yield curve over the remainder of the year. The gap between two-year and 10-year swap rates is currently 1.55% (3.80% against 5.35%). Do not rule out a parallel shift up over the next 12 months with both two and 10 year rates being 1.00% higher and the gap the same at 1.55%.
Corporate borrowers with increasing or new debt levels who need to fix long-term to meet hedging policy limits, should perhaps avoid 10-year swap rates above 5.50% and look to fix a greater percentage in the five and seven year maturity region at 4.65% to 5.00% swap rates.
NEW ZEALAND DOLLAR MARKET COMMENTARY
USD expected to re-exert itself
The risk to exporters of the NZD appreciating further above 0.7800 and onto 0.8000 has reduced over the last week with the EUR/USD reversing in the global FX markets from $1.3800 to $1.3570 currently. The AUD remains strong at 1.0140 against the USD with hard commodity prices underpinned by rising manufacturing output everywhere except China. Whether the NZD/USD rate can depreciate quickly over coming weeks to the low 0.7000’s to fulfil our forecasts, depends heavily on developments with China and commodity prices.
I still believe that the Chinese monetary authorities will continue to tighten policy with higher interest rates and bank credit ratios. They are worried about inflation and will be prepared to sacrifice some GDP growth to keep the inflation tiger in the cage. The Chinese are restricted on monetary policy management with one arm tied behind their back with their rigid exchange rate regime. Their control of inflation would be much more effective if their currency was allowed to appreciate. However that is not about to change!
Tighter monetary policy in China should result in a pull-back down in hard commodity prices and a lower AUD value. We are now observing the fourth occasion of the AUD trading above parity of $1.000 to the USD, however being unable to sustain and hold the gains. Where the AUD goes from here is directly associated with USD movements against the Yen and Euro.
The stronger economic data coming through in the US continues to roll into the markets and this has to be more positive for the USD currency value vis-a-vis the Euro and Yen. Europe is not about to increase their interest rates anytime soon and we have yet to see any response from the FX markets to the cut in Japan’s sovereign credit rating. Any slower growth in China would not be good news for the Japanese economy and this may force policy changes there to really weaken their currency to compensate. A stronger USD back to $1.3000 and 85.00 against the Yen would certainly pull the AUD and NZD off a few cents.
Bill English attempts to rationalise the irrational currency markets
Finance Minister Bill English was interview by Bloomberg last week and he sees the high NZD value against the USD being an “impediment” to growth this year; however he does not see any reason why the NZD would go higher still. He is very conscious that the Government does not do anything to put upward pressure on the currency. RBNZ Governor Bollard has already stated that a tighter fiscal policy from the Government will allow monetary policy to be looser for longer and thus in turn weaken the NZD. However as we all know, it is not the NZD side of the exchange rate pair that has caused the NZD/USD rate to be at 0.7700, it is the weaker USD on global FX markets.
Mr English is probably walking a higher tight-rope than the RBNZ Governor these days. He has the tricky balancing act of being fiscally prudent, however getting National re-elected back into Government in November, therefore cannot slash and burn Government spending. Additionally, he has to keep the chaps happy at Moody’s and S & P. He also cannot pee-off foreign investors into our Government bonds (who are funding his fiscal deficit) by doing something that causes the NZD currency value to slide dramatically i.e. the investors lose money in NZ. Bill English indicated “the biggest dangers for New Zealand include a slowdown in China, house-price bubble bursting in Australia or a spreading in the European sovereign-debt crisis” My take on those risks is that all three would cause the NZD to depreciate, exporters would cheer and GDP growth would be higher in New Zealand this year than otherwise would be the case!
For the meantime we cannot have it all our way. The record high and still rising NZ export commodity prices in many ways justify and support the higher NZD value. However it would be great for the economy if the USD strengthened internationally and our agriculture export commodity prices stayed up.