Fixed interest investors who have been investing their funds in short maturities to benefit from higher short-term and long-term market interest rates later this year, have just experienced a sharp lesson in “event risk” with the Christchurch earthquake and the OCR cut keeping interest rates now much lower for much longer. It does not pay to have all your eggs in one basket; however you might be surprised at how many retail investors have never invested their money for terms greater than 12 months. These investors may have been getting 5.00% deposit rates form the banks over the past year, however many banks have now slashed such rates to 4.00% because they no longer need to attract money in as they are not lending it out the other side.
The now steep upward slope of the yield curve tells us that the markets expect interest rates to increase sharply in 12 months time. Can and should retail investors be patient and wait for the uptick, suffering the lower returns in the meantime? Or should retail investors buy a five-year corporate bond in the marketplace today at 5.80%-6.00% and be happy at that return. As always, the answer is somewhere in between, emphasising the requirement to have a mix of both short-term and long-term investments in the portfolio, so as to have some hedge against the type of event risk we have just seen.
There are similar sorts of challenging yield curve/market risk questions for borrowers as well at this point in time. Corporate borrowers with high levels of fixing out to 10 years forward with swaps will be viewing the “opportunity cost” of paying between 5.00% or 6.00% under fixed-rate swaps against floating rates now below 3.00%.
The problem with switching immediately to a higher level of floating is that when these rates start to increases in early 2012, the three to 10-year market swaps rates will be substantially higher than where they are now. It makes no sense to close-down long-term swaps now and go floating, unless those long-term swaps were entered at the market lows of 4.50% and 4.75% (24 months and seven months ago) and are heavily “in-the-money”. These swaps can be shortened in term to generate lower one to five year swap rates. I would hold-off from transacting these shorteners until seven to 10 years swaps rates move up another 40 or 50 basis points.
For new borrowers or borrowers forecasting increased debt levels, there must be merit in fixing 60%/70% in the three to five year maturities at the current swap rates of 3.70% and 4.35%, given the NZ growth and inflation outlook after 2011. I do not see these three to five year swaps rates going any lower than where they are now. APRM’s updated forecast is for the three and five year swap rates to be 1.00% higher in 12 month’s time. That forecast is based on US 10-year Treasury Bonds moving higher and dragging the three to 10-year NZ swaps up with them. Add on the 2012 inflation and growth scenario and such forecasts may not be too far wide of the mark.
Whilst US Treasury Bond yields have moved down recently to 3.40% on the investor “flight-to-quality” from the Middle-East tensions, all the other inflation, growth and employment leading indicators in the US economy point to 4.00% yields over the next 12 months. As mega-fixed interest fund manager in the US, Pimco, say “who is going to buy US Treasury bonds when the Federal Reserve stop buying their USD75 billion per month when the QE2 programme ends in June?” – The massive Fed buying to date has hardly forced yields lower; remove that buyer from the market and the sellers take over. For this simple reason it is very easy to forecast US 10-year Treasury bond yields increasing to 4.00% this year. Again, add on the higher inflation and economic growth factors and the forecast takes on some reasonable credibility.
NEW ZEALAND DOLLAR MARKET COMMENTARY
Despite the official interest rate cut, the AUD still holds the key to Kiwi dollar direction
The NZD/USD exchange rate has rebounded upwards by one cent from the low of 0.7330 reached after the official interest rates were cut by 0.50% by the RBNZ on 10 March. The initial market reaction to sell the NZD down from 0.7400 on the 0.50% OCR cut announcement was understandable as the moneymarkets were only pricing-in a 60% probability of a full 0.50% reduction. However, the FX markets have rapidly moved on from domestic interest rates determining the NZD direction and have since returned to the main driving factor - what the Australian dollar is doing.
Following an upbeat assessment of the outlook for the Australian economy by the RBA, the Aussie has again appreciated back upwards against the USD to $1.0150. The A$ has encountered resistance as these levels previously over recent months ( see chart below) and it is something of a surprise that it has been bought back up.
Recent economic data out of China has not been as strong as the markets were expecting and the CRB Commodities Index has recoiled from highs of 365 to 352. Lower commodity prices and less than positive Chinese economic data is normally quite negative for the AUD against the USD, so the recent gains to $1.0150 may be short-lived. It will take a significant sell-off in global hard commodity price to force the AUD down from here. That commodity market selling can only come from the following sources:-
§ Chinese demand slowing down and the speculative element deciding to take their profits.
§ Fund managers who have been large buyers of commodities as an asset class over recent years deciding to reduce their weightings to the over-heated commodities markets.
§ The high oil prices slowing global economic growth and reducing commodity demand.
§ US short-term interest rates increasing to end the free financing carry on holding commodity inventories, however that appears to be more of a 2012 story at this point.
An overdue downwards correction in global commodities markets could come from any of these factors. The Kiwi will follow the Aussie dollar down if and when it does occur.
USD poised to make gains against Euro and Yen
What is also surprising in the global currency markets is the inability of the USD to make gains against the Euro when European sovereign debt problems are in focus again and US economic data continues to be very positive. The indecision about the near term direction of the USD itself could be related to mixed messages or the mixed interpretation by the markets of messages coping out of the US Federal Reserve. It seems that there is a growing chorus within the Fed not to extend the QE2 monetary stimulus that expires at the end of June. However, recent statements from Governor Ben Bernanke hinted at the continuation of monetary stimulus for the US economy.
The manufacturing, services and consumer confidence economic data suggests that the US economy is starting to progress under its own steam and therefore does not require any additional propping up. Further easing moves from the Fed Reserve is negative for the USD, whereas evidence of self-sustaining expansion is positive for the USD because at some stage US short-term interest rates will need to be increased again. For the meantime, the FX markets have come to an impasse, not prepared to sell the USD above $1.4000 against the Euro, however also not prepared to buy the USD aggressively in case Bernanke prints more dollars. The latter outcomes does seem unlikely, therefore the view is that the USD will make gains against the Euro over coming months and this should push the NZD/USD rate towards 0.7000.
The Japanese earthquake is not necessarily negative for the Japanese Yen, as like Christchurch, the rebuild will eventually require buying of Yen as international re-insurance monies are remitted into Japan. The Japanese Government will be issuing more debt to global bond markets; so long term Japanese interest rates may rise over time. In the short-term, emergency monetary measures to ensure liquidity in the markets should be Yen negative. The Bank of Japan will intervene in the foreign exchange markets if the Yen starts to strengthen. The Australian dollar does follow JPY movements against the USD; therefore any early Yen weakness on lower Japanese and Asian equity markets may pull the AUD down against the USD over coming weeks.
The NZ Government’s budget in May will be the next focus of the local FX market, with Finance Minister Bill English working hard to please the credit rating agencies as well as voter expectations. Before that, the December quarter’s GDP figure on 24 March may cause NZD selling if it is a negative number.