Conflicting forces will work to keep interest rates at modest levels

By Roger J Kerr

While the economic and financial market turbulence in Europe over recent weeks has largely been manifested through currency and equity markets, there are a number of implications for our short and long term interest rates. US long-term 10-year Treasury bond yields have decreased from 3.70% to 3.20% (allowing our 10-year swap rates to fall to 5.75%) as investors look for a safe-haven for their money. International credit spreads and thus bank funding margins have moved back upwards as markets adopt a far more defensive and cautious approach amidst the global market turmoil.

 Conflicting forces on to the local interest rate market also come from:-

- An almost unbelievably positive increase in NZ employment in the March quarter that on the surface points to a higher GDP growth outcome this year. I am very suspicious of the March jobs statistics and the big difference between actual and seasonally adjusted results. The immediate reaction by the interest rate markets was to sell swap rates higher, but the increases were short-lived in the face of the subsequent global market turmoil.

- Increases in headline inflation this year due to the GST increase and ETS impacts need to be kept in perspective and separated out by the RBNZ in setting monetary policy/short-term interest rates through 2010 and 2011. The RBNZ need to explain and condition expectations that the CPI increase is a one-off and caused by economic policy changes.

- The record high terms of trade and export commodity prices now assisted by a lower NZD/USD exchange rate, auger well for an export led-economic recovery. As improved profitability and investment in the export economy feed through the provinces into the cities next year, the domestic economy will lift and produce a stronger GDP growth performance in 2011. The aforementioned scenario is dependent upon our export commodity prices staying high, which in turn depend upon the global economy.

- Bill English’s budget is the most positive economic policy initiative for a very long time. The Government clearly understands that the NZ economy needs to continue its re-balancing process from borrow/spend to save/invest. The lower tax rates should assist stronger economic growth and increased investment. The 2008/2009 credit crunch and economic recession started the much-needed re-balancing of the economy, monetary and fiscal policies are now furthering those adjustments. Over coming years stronger tax revenues coming into the Government than forecast due to stronger GDP growth, coupled with lower NZ Government bond interest rates than originally forecast add up to lower fiscal deficits and less reason for 10-year swap rates to be much above 6.00%.

Add it all up and NZ short-term interest rates will be around 4.00% to 5.00% over coming years – a far cry from the 6.00% to 8.00% levels of yesteryear.

----------------

* 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