Opinion: Under-performing economy likely to weigh on interest rate decisions

By Roger J Kerr As we enter the New Year there are wildly divergent views on how the NZ economy will perform this year, therefore marked differences in view as to the timing of interest rate increases from the current loose monetary settings of a 2.5% OCR. Over the next two months I would not expect the short-term interest rate market to move away from their current forward 90-day market pricing of 0.50% lift by March and 2.00% to 4.50% by December. However that does not mean that the RBNZ will deliver to current market timing/amount expectations. The longer the NZ dollar exchange rate remains above 0.7000 to the USD the greater the likelihood that GDP growth is closer to our 2010 forecast of +1.50% than the overly optimistic forecasts of the RBNZ and bank economists. A lower GDP growth track in 2010, due to the adverse impact of the high currency value on the export sector, means lower inflation risks, excess capacity for longer and thus postponement of interest rate increases. The NZIER quarterly business confidence survey out Tuesday should confirm the increasing spare capacity (lower capacity utilisation percentage) in the economy, thus a benign inflation environment. The CPI inflation numbers for the December quarter are due out next week and will also be very low, possibly as low as +0.1% or +0.2% for the quarter. The September quarter's GDP growth figures which were released on 23 December were barely positive at +0.2%, considerably below prior concensus forecasts. A rebound in forestry and oil/gas exploration in the third quarter saved the economy from contracting into negative again. Over the 12 months to 30 September 2009:- - Fishing/Forestry industry sector contracted 8.5% - Manufacturing contracted 11.9% - Construction contracted 10.3% - Wholesale Trade contracted 10.7% - Retail contracted 2.9% - Transport/Communication contracted 4.9%. Those industry sectors are a big part of the total economy, so it is hard to see companies in these sectors lifting their business investment by 10% this year, as the RBNZ forecast. However, some sectors did expand namely - Agriculture + 3.6% and - Finance/Business Services + 7.1%. Dry climatic conditions could temper agriculture production over coming months and the services sector will not continue to expand at that rate if the underlying heartland of the economy is static or contracting. Higher export commodity prices are off-setting the adverse currency impact to some extent, but overall market expectations for the NZ economy in 2010 are too optimistic. It will be a slow hard grind back to economic growth in 2010 with many sectors still really struggling (despite what the overly optimistic business confidence surveys are suggesting) While short-term interest rates look set to stay lower for longer, it does not mean that the interest rate market is devoid of risks for borrowers and investors. Market supply and demand factors globally look set to push long-term Government Bond yields higher over 2010. US Treasury Bond auctions were running into investor resistance in the very long tenors late last year. US 10-year Treasury Bond increased from 3.20% to 3.80% in December and appear likely to go higher to 4.00%. In this environment NZ five to ten year swap rates are unlikely to move lower and the more likely increases will render the yield curve slope even steeper. For borrowers there is absolutely no incentive to fix for long-term periods, whereas investors buying securities on a "buy-to-hold" basis are being well-rewarded for investing long. "”"”"”"”"”- * Roger J Kerr runs Asia Pacific Risk Management. 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