It's neither an L- or W-, its a square root recovery

By Roger J Kerr

As we expected, the RBNZ have revised downwards their GDP growth forecast for this year as the domestic economy remains flat and business investment has not lifted as they were anticipating.

However the more dovish assessment (they were too optimistic for 2010 previously) of our economy going forward does not change the fact that an OCR at 3.00% is still a very stimulatory monetary policy setting.

The RBNZ are correct to say that this setting is not appropriate and too loose for the inflation and economic outlook.

The weaker track of the economy this year has caused them to hint at a pause in raising rates at some stage. I still do not see them actually doing this because in three of four months time they will be peering down the barrel of a 5% CPI inflation rate and projected 4% GDP growth for 2011.

Add to this scenario the push from workers for 4% wage increases as they have not had an increase for two years and the CPI is at 5% (as Governor Bollard warned about in his OCR statement) and the future inflation risks increase further.

How can the RBNZ justify a stance of leaving interest rates below 5.00% against this economic environment? 

It is interesting to note that even though the moneymarkets have priced the yield curve lower over recent weeks, the various bank economists still have their 12-month interest rate forecast even higher than APRM’s own forecasts i.e. 90-day rates at 5.00% and 10-year swaps above 6.000%.

The one big proviso on the “no pause” view is the Kiwi dollar value. If the NZ dollar holds above 0.7000 over the next several months and our export commodity prices ease back, the RBNZ will be inclined to nudge the dollar down with a “no increase” OCR decision rather than just talking about its high value being inconsistent with the economic fundamentals.

At the end of the day, whether we actually experience the increases in interest rates across the yield curve that we are forecasting for the next 12 months, depends on global economic/market developments not what is going on in New Zealand.

The fundamental question for three to 10 year interest rates is whether the US 10-year Treasury Bond yields can stay at these low levels or not?

My view is that they cannot, and the massive maturities and new debt being issued by the US Government has to force the yield higher to attract the investors in sufficient volume.

As US economic data improves over coming months I would expect the bond yields to be increasing above 3.00%, not staying below that level.

There has been much debate around the place for the last 18 months as to the shape of the global economic recovery. The “L” and “U” shaped recovery lines on the GDP growth chart were in-vogue for a while until we had the late 2009/early 2010 inventory re-build phenomena.

Over recent months the “W” shaped recovery (i.e. double-dip recession) became more popular; however its support is now waning.

All along, our view has been the global economic recovery will be shaped like a “square-root” sign ( √ ) with an elongated, gently rising tail added i.e. down, up and then a long hard grind slowly upwards.

The dismissal of the “L” and “W” shaped recoveries means that long-term Government Bond interest rates will increase from the current low levels with further decreases in yield highly unlikely.

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 * 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