Opinion: Has market pricing of future interest rates overshot?

By Roger J Kerr The prospects for the global economy and the NZ economy, and thus global and NZ financial markets, in 2009 are at this time very cloudy indeed. The outlook is highly uncertain and unpredictable to say the least. The only matter I have some small certainty about is that 2009 is going to be much less volatile than 2008. Everyman and his dog are hunkering down for a very subdued year. In this environment many are reluctant to provide a forecast and view on the economy and interest rate movements. My firm's views on the outlook for interest rates are constantly under scrutiny, as events unfold. The moneymarkets continue to price NZ interest rates considerably lower, the inter-bank Overnight Index Swap forward curve has interest rates as low as 3.50% later in the year. The 1-year wholesale bank swap rate is 4.15% today, against a 5.00% OCR and 4.67% 90-day rate. The bank economists are talking of a 0.75% cut to 4.25% in the OCR at the end of January, followed by more cuts. The moneymarkets and bank economists view appears to be based on US interest rates being at zero per-cent, UK interest rates at 1.50%, therefore 3.50% is where we are headed in their opinion. I cannot be so sure that NZ interest rates need to go that low and have they considered the dangers to inflation in 18-24 month's time if interest rates are lowered to such levels. The RBNZ always reserves judgment to change their forecasts/view based on new economic data and trends coming to hand. Right now, 3.50% interest rates in NZ (i.e. super-loose monetary settings) under our RBNZ Policy Targets Agreement cannot be justified unless the RBNZ is forecasting the annual CPI to go well below the bottom limit of 1.00% pa. in 18 to 24 months time.  They are certainly not forecasting that to occur. Their GDP growth forecast for the March 2010 year is 1.3% (annual average). Their CPI forecast is currently +2.7% pa for the March 2010 year. They would have to adjust their GDP growth to a negative number to support a CPI forecast less than 1.00%. I just do not see that happening. The economy in 2009 may turn out to be weaker than I was anticipating if export commodity prices continue to fall and we do not get the export-led recovery until 2010. However, it is a very long bow to draw to forecast inflation below 1.00% in 2010. The RBA in Australia has gone on "hold" in respect to further interest rate cuts. After a 0.50% cut in a couple of weeks which will take our OCR to 4.50%, the RBNZ will also be on hold in my view. Like everyone else they will be looking at the forward indicators of consumer and business confidence as a guide to when the economy may pull itself out of recession. If Alan Bollard has learnt any lessons from history he will know that NZ households tend to want to buy property when mortgage interest rates go below 7.00% (i.e. considered cheap money). We are at that point now and he will be aware of the dangers to inflation in 18 to 24 month's time if interest rates are pushed substantially lower from current levels. The local moneymarkets and bank economists have lost sight of the RBNZ inflation mandate in my view, and for this reason we see short-term interest rates unlikely to go below 4.00% to 4.50%. Long-term interest rates (10-year swaps) may have already bottomed at 4.80% a few days ago. US Government Treasury Bond yields hit a low of 2.00%, but have since traded higher to 2.60%. I cannot see anyone buying them at 2.00% to force yields even lower, however the weight of selling to force them upwards may start to accumulate from here.   "”"”"”"”"” *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.