Roger J Kerr says the risk of increasing three to 10 year interest rates is very real and immediately upon us

By Roger J Kerr

While the total focus of interest rate market commentators in New Zealand has been the low inflation environment and thus the RBNZ “on hold” for another 12 months, the real risk and driver of medium to long term interest rates has very little to do with New Zealand at all.

The OCR and thus 90-day market interest rates may well remain at 3.50% for another 12 months, however totally independent to the NZ economy and that scenario going forward is the fact that our three to 10 year term interest rates follow the direction of US Treasury Bond yields.

The risk of increasing three to 10 year interest rates is very real and immediately upon us.

There have been a number of false starts to US bond yields increasing off their lows over the last two years. However, US bond yields have again been lifting over recent weeks as global fixed interest investors took the opportunity of the stronger US dollar in FX markets to reduce their weightings of bond holdings (realising the cash gains on both the currency and bonds).

As US short-term interest rates increase over the second half of 2015, further increases in their long-term bond yields can be expected.

New Zealand bond and swap interest rates have moved in lock-step with US bond yields for many years, however over recent weeks the 50 basis point increase in US 10-year bonds from 1.60% to 2.10% has not been matched by the same magnitude of increase in our 10-year swap rates.

Investor demand into NZD denominated Kauri Bond issues (offshore borrowers issuing NZD debt and swapping back to their own currency) has for the meantime held our swap interest rates down.

The 10-year swap rates have only increased from 3.65% to 3.85% over the same time period the US yields have increased 0.50%.

History tells us that our 10-year swap rates do not diverge from the US bond yields in this manner for very long.

A catch up seems inevitable.

The US bond market is not the only bond market to suffer from investors selling and sending yields higher in recent weeks, German 10-year Bund yield have snapped higher from 0.08% to 0.36%.

Another 0.50% increase in US bond yields from 2.10% to 2.60% over coming months could well see NZ 10-year swap rates increase by up to 1.00% to 4.85%, to return the correlation to the relationship of June/July last year. 

Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com