Roger J Kerr says the markets misread three important signals, and now the risk is elevated inflation. Your view?

 By Roger J Kerr

The reversal back upwards in short-term wholesale swap rates over the last two weeks is testimony to the fact that interest rate markets previously priced-in a high probability of European Armageddon and a weak NZ economy in 2012 – both of which are not happening.

At one point three weeks ago the moneymarkets were pricing-in 0.50% of future cuts to the OCR, all participants in the market being banks, investors and borrowers taking far too much notice of Australian interest rate pricing and incorrectly deducing that what happens there automatically occurs here.

Wrong on that count.

The markets were then pricing in a major event risk of Europe completely falling over and the world economy going into a tailspin.

Wrong on that count as well as the scenario of an immediate Greek exit form the Euro was squashed by the Greek far-left political parties failing to get the support they expected.

The money markets remained pessimistic about the local economy following various commentaries of the NZ economy 'struggling' and 'stalling'.

How wrong they were on that final count as well.

The stellar March quarter GDP result sending a searing reminder to all economic forecasters and their followers of what actually drives the NZ economy - that is, rain, sun and grass-growth.

However, it was not just the strong agricultural production that was the highlight of the 1.1% GDP expansion. The lift in activity was across the board with manufacturing, wholesale trade, services and mining all increasing.

Some have argued that the growth was overstated as it was all inventory build up.

My answer to that is, so what; Fonterra are holding wholemilk powder stocks back to help the international price recover and their strategy appears to be working judging by the last two GDT on-line dairy auctions. They will export the milk powder eventually, so no worries there.

The net result of the GDP outcome is that the NZ economy is on a higher growth trajectory that what most imagined.

With that comes elevated inflation risks earlier than what most expect. Hence the sea-change in short-term interest rate market sentiment and direction.

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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