The current picture and outlook for interest rates has changed dramatically as a result of the Christchurch earthquake disaster. The interest rate yield curve is clearly now going to be steeper for longer this year, as short-term interest rates remain low and the long-end is driven by US Treasury Bond movements.
Investors who were anticipating higher market interest rates in the second half of 2011 will now have to wait six further months before seeing any lift. Both retail and institutional investors will therefore be considering any five-year offerings of corporate bonds at yields above 6.00%. That expected investor market demand will not be met by the large NZ prime corporate borrowers who have already filled their debt requirements from the longer-term US private placement debt market. Therefore expect to see the second-line corporates issuing new bonds to the investors and repaying shorter term and pricier bank debt.
I anticipate that the RBNZ will deliver to market and economist’s expectations of a 0.25% or 0.50% cut to the OCR on March 10th, more as a symbolic and psychological gesture to show that they are doing what they can to assist business conditions and confidence in the aftermath of the earthquake disaster. Let’s hope that the lending banks gets the message that they may also have to sacrifice some margin compression and drop their base lending rates to SME’s and home mortgage borrowers. Just because the OCR is cut it does not automatically reduce the banks’ cost of funds. The banks cost of funds is already well established and fixed at 5.00% plus from the rates they have paid retail depositors and from higher cost longer-term offshore debt issues. The core-funding ratio imposed and regulated on the banks by the RBNZ since the GFC means that there is no longer a direct connection/linkage between the OCR and the banks’ funding costs. Without the goodwill of the banks to come to the party on this, the OCR cut will have no benefit for most borrowers. It would be useful if the RBNZ Governor properly explained this bank cost of funds situation in his March 10th Monetary Policy Statement. The pressure is on the banks from the RBNZ and Government to lower floating and fixed rate mortgage lending interest rates. Market wholesale one, two and three year swap interest rates have decreased 0.30% to 0.40% since last Tuesday (back to March 2009 lows). However, the swap markets are “non-funded” in that they do not involve physical lending and depositing of the principal amounts. The swap rate falls are not necessarily mirrored by the banks’ cost of funds reducing for those time periods.
Interest rate hedging strategies for borrowers
Corporate borrowers with new debt or increased debt to hedge should now consider minimal fixing in the five to ten year maturity bucket and maximise fixing in the three to five year time period where swap rates between 3.80% and 4.40% would appear to be very attractive. Borrowers in this category should seek to be no more than 65% fixed, given the recent events and short-term rates staying lower for longer.
Borrowers with an existing high percentage of fixing, particularly in the five to ten year maturity bucket, should start to look at “shorteners” to restructure longer-dated swaps at higher rates into lower-rated shorter term swaps. The ideal time to shorten the duration of swap portfolios is when 10-year swap rates have reached a high point and are expected to reverse downwards. Clearly, this is not the case currently with five to ten year swaps at more risk to increases from higher US Treasury Bond yields from here. However, the steep upwards sloping curve from the reduction in short-term swap rates does offer the value to generate lower fixed rates in the one to five year maturity period. Borrowers with existing fixed swap portfolios could not have predicted this “event risk” which will keep floating rates lower for much longer in 2011, however they can take the opportunity to lower their weighted-average debt funding costs be shortening their duration.
Financing Christchurch’s re-build
It may be too early for such conversations, however central and local Government leaders need to quickly consider the alternative debt financing options available to rebuild the city. Businesses and commercial activity will rapidly abandon Christchurch unless a bold rebuild plan with plenty of incentives to stay is actioned. Financing methods that springs to my mind, and which others will also be indentifying, include:-
- The prospective new Local Government Financing Agency will be a godsend vehicle for Christchurch City Council to borrow large sums from international wholesale, as well as domestic debt markets.
- Christchurch City Council issues its own retail “Earthquake Bonds” to Mum and Dad investors throughout NZ at a lower than market interest coupon to capture the mood of the nation (akin to the War and Liberty Bonds that rebuilt UK cities after the second world war).
- Central Government directly debt-financing special “economic reconstruction zones” in Christchurch’s CBD to spread the debt burden across the entire nation.
- Public Private Partnership (PPP’s) financing structures for major infrastructure and property financing. Lateral thinking is required to invite in big Australian and Korean construction companies to rebuild the inner city, as the local industry does not have sufficient resources to do the job quickly enough.
- At some future date (say in two or three year’s time) Christchurch City Holdings selling-off minority shareholding stakes in their airport, port and electricity network companies by way of stock exchange listed IPO’s. It’s not the time to be considering this right now.
New Zealand’s top 50 companies have been asked by the Government for ideas and help; however the rebuild must not be confined to only benefiting NZ construction companies. We should utilise international expertise and resources for the rebuild, just as we have accepted such specialist resources for the urban rescue operations.
NEW ZEALAND DOLLAR MARKET COMMENTARY
Earthquake disaster changes timing of forecast NZ dollar dip and recovery
The value and direction of the NZ dollar seems rather inconsequential and irrelevant as the nation reels from the largest natural disaster ever experienced in New Zealand. It is far too early to be accurately estimating the economic impact of the Christchurch earthquake, however what is apparent is the +3% GDP growth forecast for this year is postponed by 12 months to 2012. The quake is clearly negative for the economy short-term, however very positive in the medium to longer term when the massive re-build is added on top of the record high export commodity prices we are currently enjoying.
What all this means for the NZ dollar currency value is that the down/up direction and pattern forecast for this year is pushed further out in timing. It was previously expected that increasing short-term interest rates in New Zealand in the second half of 2011 would be pushing the NZD back up again on its own accord at that time. Any official interest rate increases are now going to occur much later (i.e. early 2012) as the RBNZ have to be seen to be doing the right thing to assist and help the painful recovery from the earthquake disaster. A 0.25% or 0.50% cut in the OCR on March 10th has to be viewed as symbolic and psychological only, as the reality is that the banks’ cost of funds will not automatically reduce with the OCR decrease. Bank base lending rates to small and medium business borrowers are unlikely to change. However, there will be public/government pressure on the banks to be doing their bit to assist these businesses in a time of crisis. A further easing of monetary policy now, near to a time when the markets were expecting the RBNZ to start removing the emergency monetary stimulus put in place in March 2009, has to be negative for the NZD.
Unsurprisingly, the NZ dollar was immediately sold in the FX markets when the quake headlines hit the newswires last Tuesday. It was a natural reaction to sell the Kiwi down 1 ½ cents to 0.7450 on the news as international currency market participants speculated on the implications for the economy. The NZD has stabilised around 0.7500 since the initial selling, however it is instructive that the NZD has been unable to follow the AUD higher against the USD over recent days. As a consequence, the NZD/AUD cross-rate has dropped to new lows of 0.7380. The overall Trade Weighted Index (TWI) has decreased from 67.70 before the quake to below 66.30.
Over coming months and years the “New Zealand specific” forces on the NZD exchange rate direction may be assessed as follows:-
- “Lower for longer” interest rates in 2011, due to the earthquake disaster, postpone any individual NZD strength until 2012.
- Provided agricultural export commodity prices hold their recent gains, 2012 could be a big years in economic growth terms, thus increasing interest rates and currency value in 2012.
- Massive offshore reinsurance payments for the Christchurch re-build coming into New Zealand later this year and 21012 are NZ dollar positive, as the Kiwi dollars have to be purchased across the FX markets. The billions of one-off payments will reduce the Balance of Payments deficit from 3% to 1% of GDP.
- International share and bond investors abandoning their NZ holdings as a result of the quake are unlikely. The second largest holder of NZ Government Bonds, US fund manager Loomis Sayles, are reported as wanting to buy more NZ bonds if the currency comes off another 5% to 10%. Daiwa Asset Management is the largest holder of NZ Government bonds.
The upcoming “global” forces on the NZD/USD rate are more difficult to predict with accuracy, however they may be summarised as follows:-
- Comparative economic fundamentals between Europe and the US suggest a EUR/USD exchange rate at $1.2000, not the current $1.3750. A stronger USD this year should pull the NZD/USD rate to below 0.7000.
- Stronger US employment and ISM data over coming months is USD positive.
- The Chinese leadership is worried about increases in inflation (food and housing prices) and seems likely to tighten monetary policy a lot further. Eventually a slowdown in Chinese demand has to be negative for sky-rocketing hard commodity prices and the Australian dollar.
The NZD/USD exchange rate does follow the AUD/USD and EUR/USD rates closely, so the implications are obvious.
The Christchurch earthquake has changed the timing of the forecast NZ dip and recovery; however the overall pattern remains the same.