Opinion: Three alternatives to how the bottom forms

By Roger J Kerr With 1-year swap rates trading at 5.10% and the FRA market pricing 6 and 9 months forward 90-day rates at 4.80%, there is certainly a confident expectation in the moneymarkets that the RBNZ will take the OCR to 5.00% and possibly even lower. Have the markets become carried-away with what's happening around them with plummeting equity markets and global economies sliding into recession? It all depends whether you believe that the monetary and fiscal stimulus measures various Governments and Central Banks have taken so far to prevent extended economic recessions/depressions will work or not? - and the timing thereof, in terms of the restoration of investor and consumer confidence. I am in the camp that believes the stimulus packages will do the job, but the timing of some recovery is debatable. What I also firmly believe is that the New Zealand economy will recover to a positive GDP growth path in the second half of 2009 with export growth leading the way. Bank forecasts of the OCR going to 4.00% and even lower are an over-reactionary response to short-term sharemarket volatility. The world economy is dislocated, but it is not fundamentally broken. It is only a question of time, in my view, before the monetary and fiscal stimulus now happening lifts consumer and investor confidence back up again from its depths of despair. In these very uncertain times it is of course foolhardy and dangerous to be absolutely certain of your forward view of how the economy and interest rates will be behaving in 12 months time. What we can do is ascribe probability weightings to alternative/potential scenarios and adjust those percentage weightings as events unfold over coming months. In midst of the current plummeting interest rates to record low levels this may also seem a bit of a cop-out, but in 12 months time it will be worthwhile looking back to see how accurate the scenarios were. Scenario 1: "The Short U" Global financial/investment markets stabilise at current levels. By February/March 2009 there is evidence that the worst part of the economic tsunami is over and folk are forecasting an improvement in investor and consumer confidence. There is evidence that the fiscal/monetary stimuli are starting to work globally. In New Zealand, our agricultural export commodity prices in NZD terms hold at record high levels and buying demand is improving. The RBNZ forecast a return to positive GDP growth in the second half of 2009 and CPI inflation forecasts are well above 1.00%. Under this scenario the bottom of the interest rate downtrend is November 08 to February 09 with 90-day rates no lower than 5.00% and the yield curve has a positive upwards slope. Probability weighting = 50%. Scenario 2: "The Long U" It takes longer for financial/investment markets to stabilise. Return of investor/consumer confidence does not emerge until much later in 2009 and further stimulus measures are necessary. Our export commodity prices continue to fall but stabilise by mid-2009. The RBNZ lower inflation forecasts to 1% and ease monetary conditions further to a 4.25%-4.50% OCR in early 2009. Probability weighting = 30%. Scenario 3: "The Ugly L" This is the Armagedon scenario to satisfy the doomsayers who like to think it is the end of the world as we know it! Equity markets continue to fall at the same rate as recent months. Economic depression sets in globally and the world enters a Japanese-type period of zero interest rates not being sufficient to entice anyone to take a risk. Commodity prices defy their forward curves of higher prices and plumb new lows. The falling commodity prices are bad news for New Zealand dependent on an export-led recovery. The RBNZ have to lower interest rates to 3.00% to combat a deflation scenario. Probability weighting today = 20%, but likely to decline over coming weeks in my view.    --------------- *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