RBNZ interpretation of core inflation surprises, may push out initial rate cut expectations. Low US inflation changes market expectations of the next hike

By Jason Wong

The risk-off move saw a decent rally in US Treasuries across the curve, with the 10-year rate falling 11 bps to 1.94%, with the yield currently at the low for the day.

US CPI data came in on the soft side of expectations, with housing data mixed.  Fed fund futures have rallied hard again, with the Dec-16 future up 6 bps in price.  That means only 21 bps of tightening is now priced in for this year, or not even one full rate hike.

Locally, the weak NZ CPI figure drove an immediate rally across the bank bill futures curve, as the market began to seriously contemplate the Bank cutting rates as soon as March.  Dec-16 futures rallied by 6 bps while Dec-17 futures rallied by 10 bps. 

While the core measures of inflation like the trimmed mean and weighted median also looked very weak, the RBNZ’s sectoral factor model estimate of core inflation released later in the day showed a surprising lift to 1.6% y/y.

So while a March rate cut looked like a no-brainer at 11am, by 3pm I wasn’t so sure.

However, the market largely ignored the positive reading of the RBNZ’s core measure.  By the end of the day the OIS market was pricing the first full 25 bp cut by the June meeting and 16 bps of cuts priced in for March, representing a 64% chance of a cut at that meeting.  Less than 5 bps of easing is priced in for next week’s OCR decision.

The 2-year rate swap plunged by 9 bps to 2.59%, its lowest close in 3 years.  There was a flattening of the yield curve, with the 10-year swap rate down by “only” 5.5 bps to 3.42%.  The overnight rally in US Treasuries should put further downward pressure on rates.

The 2-year swap rate is now close to the lower end of its expected trading range for 2016 of 2.50%-2.90%.  There is a risk that the rate tests the 2.5% level should the RBNZ open the door for further easing next week.