By Roger J Kerr
The interest rate yield curve is set to steepen further with longer term interest rates driven higher by rising US 10-year Treasury Bond yields and short-term rates staying down as the economic outlook has less certainty about it.
The gap (spread) between our two-year and ten-year wholesale market swap interest rates has widened to 115 basis points as the stronger than expected US February jobs’ numbers on Friday night increased their long bond yields to 2.05%.
The steepness of the upward sloping interest rate yield curve should become even more pronounced as US fixed interest portfolio managers finally recognise that the US economy is starting to perform, despite the US fiscal deficit problem being a long way from being resolved.
The fixed interest investment portfolio managers do not want to be caught on the wrong side of a weakening US bond market and will be shortening the duration of their portfolios earlier rather than later - that is, selling US Treasury Bonds, not buying them, sending bond prices down and yields up.
The brighter US employment and economic outlook brings forward the timing of when the US Federal Reserve will look to end the QE monetary stimulus via bond buying. Thus, one very large and persistent buyer who has been holding US long term yields down disappears from the marketplace.
Our long-term Government Bond and swap interest rate follow the US direction due to the high percentage of foreign investor ownership of our Government bonds on issue.
A Chinese sovereign wealth fund manger sitting in Shanghai buys and holds NZ Government bonds as an enhanced yield play over and above US Treasury Bonds. The Chinese fund manger does not buy more NZ bonds if they are selling US bonds and shortening their portfolios’ respective durations.
The bond market trading fraternity understand this strong linkage and correlation, thus increasing US yields will result in higher NZ yields.
At the short-end of the interest rate yield curve two factors will hold the interest rates lower for longer than otherwise might be the case:
· As highlighted over recent commentaries, the New Zealand economic outlook is not as positive as the booming property and share markets might suggest. The North Island drought is forecast to take $1 billion off the table from rural spending this year. GDP growth forecasts will start to be revised downwards as a result. We will get an update on how the RBNZ see the material decrease in agricultural production at the Monetary Policy Statement (MPS) this Thursday.
· The threat the RBNZ hangs over the local banks to implement further macro-prudential tools to pullback credit expansion if the housing market gets too hot and threatens inflation, acts to keep short-term interest rates lower than otherwise may have occurred. Again, expect Governor Wheeler to mention these new tools at his disposal in the MPS statement on Thursday.
A steepening yield curve slope is a reasonably solid forward indicator that eventually interest rates will increase as borrowers re-centre their “paying fixed” demand to the shorter end of the curve and investors refrain from buying term securities and keep their powder dry for higher interest rates in the future by holding cash.
The 2-year/10-year swap spread can be expected to increase over coming months as the US long-term rates increase further and our short-term swap rates are temporarily held down.
A 50 basis point increase in the spread would point to the 2-year swaps rates eventually increasing to above 4.00% (currently 3.00%).
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Roger J Kerr is a partner at PwC. 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
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