Will the New Zealand interest rate yield curve be as steeply upward sloping in 12 months time as it is now? Currently there is a 2.5% gap between 90-day rates at 2.70% and 10-year swap yields at 5.20%. Whilst there is a fair amount of confidence that the 90-day rates will be moving higher rather rapidly in early 2012 as the RBNZ realise they are behind the 8-ball in respect to monetary settings against a higher inflation/GDP growth track, the yield curve slope at that time will depend whether long-term interest rates move concurrently higher.
Whilst I can see 90-day interest rates increasing by 2.00% in 2012 to 4.70%, the expected increase in 10-year swap rates will probably be limited to between 1.00% and 1.50%. Therefore, in 12 months time the 90-day/10-year gap should reduce to around 1.50%. “Neutral” monetary policy settings by the RBNZ at that time will therefore still have an upward sloping yield curve. I think it will be a very long time before we see any return to an inverse yield curve with short-term rates above long-term interest rates.
The RBNZ are going to be less reliant on jacking up short-term rates to slow the economy to control inflation in the future. The core funding ratio regulation over the banks provides them with another lever to pull and generally higher bank lending margins means that market short-term interest rates do not have to be as high as historical levels to slow the economy. More than 50% of home mortgage borrowers now on variable rate also means that the RBNZ have more immediate leverage over consumer spending behaviour. Not that the current and future inflation increases are coming from the consumer demand side of the equation anyway!
I do not see long-term swap rates being too influenced by the NZ domestic economic factors that drive the short-term rates. The factors that will determine the extent of the increase of long-term swap rates over the next 12 months include:-
§ Whether new issuance (supply) of US Treasury Bonds outweighs the buying demand after the Federal Reserve stop buying massive volumes following the end of QE2 in June? The US 10-year bond yields have moved down to 3.15% since the FOMC meeting last month and the recent “safe-haven” buying as commodities reverse direction in global markets. It is really hard to see these yields going a great deal lower; however the potential to increase to 4.00% again is very real with stronger US economic growth and associated inflation risks going forward.
§ The spread between US and NZ bonds is more likely to increase over the next period (certainly not decline) as NZ short-term rates increase earlier than US short-term interest rates. A credit rating downgrade for the NZ Government would also increase the risk premium of where NZ bonds trade above their US counterpart.
§ With NZ short-term rates forecast to increase substantially it is hard to see who the fixed rate receivers will be in the swaps market to drive long-term swap rates downwards. It will not be local fixed interest fund managers as they are more likely to be shortening portfolio durations than lengthening them. Borrowers are more likely to be fixed rate payers and the investment bank curve trading fraternity are not the force they use to be.
§ Offshore investor demand for NZ Government bonds is likely to reduce somewhat from current very strong levels. A credit rating downgrade will potentially be one factor and a high NZD value against the USD above 0.7500 will dissuade some investors (their entry point being too high).
In a years time we will still have a normal upward sloping yield curve, however not as steep as it is now.
NEW ZEALAND DOLLAR MARKET COMMENTARY
Reversal in commodity prices leaves the Kiwi vulnerable
The international and domestic buying forces that propelled the NZD/USD exchange rate to highs of 0.8100 last week suddenly seem to have lost their impetus and the Kiwi is looking more vulnerable to a sizeable correction down. Risk aversion in global commodity and sharemarkets has suddenly increased and the reinsurance related capital inflows into New Zealand have slowed down.
The direction and sentiment in global commodity markets has reversed sharply in recent days as investors start to worry about world economic growth. China has been the powerhouse behind the global growth story over recent months and commodity and equity markets have zoomed upwards in response. The dip in prices immediately after the Japanese earthquake in mid-March provided the buyers with the opportunity to add to their long positions. However the mood and direction abruptly reversed last week with silver and oil prices leading the commodity prices lower. The markets have fresh concerns about the Chinese growth rate with higher inflation outcomes recently in both China and India reminding the markets that their monetary authorities are going to continue to tighten policy.
Unsurprisingly, the Australian dollar has been hit hard with the fall in commodity prices, reversing from highs of $1.0950 against the USD to $1.0700. Weaker than anticipated Australian retail data added to the AUD selling. The Kiwi dollar followed the AUD down, dropping from 0.8100 to lows of 0.7820. The Chinese have raised interest rates four times since last November (0.25% each time) and can be expected to carry on with the tighter policy as they have not yet got domestic inflationary pressures under control. US Treasury Secretary Timothy Geithner will again request the Chinese to raise their interest rates further and allow the Yuan currency value to appreciate faster to redress global financial imbalances. Allowing foreign investors to buy Yuan securities more easily would be one way to speed up the strengthening of the Yuan currency value.
Global commodity markets have been moving up strongly over recent months due to supply constraints in many markets and the relentless Asian demand. The investment and speculative element in the commodities markets may be reassessing their strategies as the Asian growth/demand equation is perhaps not as strong as they were factoring in. Whilst the long-term trend line for commodities prices remains upwards, many see the need for a major correction downwards in prices to burn-off the speculative long-position holders. That correction may have just started.
The USD currency value against the major currencies moves inversely to commodities prices. The USD has recovered from $1.4800 against the Euro to $1.4300 at the time of writing. US economic data continues to improve, however the negative US fiscal position and the continuation of the monetary stimulus from the Federal Reserve has weighed the USD currency value down in recent months. However, the USD weakness against the Euro to $1.4800 was hard to fathom against the backdrop of the deteriorating sovereign debt situation in Greece and the Europeans struggling to agree on ways to fix the problem. The ECB having increased their interest rates once from 1.00% to 1.25%, as expected, seem a little reluctant to rush into a second or third increase.
The overall value of the US dollar as measured by the USD Index has done a U-turn from lows of 71 to rise to 75. A stronger USD on the world stage was always a pre-requisite for a lower NZD/USD rate. It looks like the USD can now recover further as US economic data out-performs European economic progress. Measures of speculative short-sold USD positions in the foreign exchange markets prior to the reversal in the commodity markets last week pointed towards an over-extended situation. The recovery of the USD cannot be surprising as the reasons for the heavy selling over recent weeks were never too convincing. Locally the FX market’s focus will on the Government’s budget statement on May 19th. If the Government does not cut its cloth to fit lower tax revenue inflows, Standard & Poors will deliver their displeasure at the deficit/debt track and downgrade the AAA credit rating. That probability sits tantalisingly at 50/50 at this point. The Kiwi dollar could be expected to fall two or three cents on its own if S & P do downgrade. The Government will be working hard to avoid that outcome; therefore close market scrutiny of the budget and how S & P react to it can be expected.
A return of the EUR/USD exchange rate to the mid $1.30’s seems much more likely now and this will deliver a NZD/USD rate below 0.7500 over coming weeks. How global investors see commodity prices and the commodity/growth currencies after that will determine whether the Kiwi dollar is above or below the 0.7500 level through the winter months.