By Roger J Kerr
The consolidation of US 10-year Treasury bond yields in the 2.55% to 2.75% over recent days is very instructive to the future direction of long-term interest rates.
Whereas the US dollar value recoiled (weakening from recent strength) in the markets last week following US Federal Reserve boss Ben Bernanke’s belated hosing down of tapering timing, the US bond market did not unwind the selling that has sent yields up to 2.60% from 1.60%.
The US bond market is pricing in a future environment of eventual higher inflation, higher growth and high short-term interest rates and will continue to do so.
Those large borrowers hoping for a pullback in long-term swap yields to execute fixing of rates they should have done months ago, look likely to miss out again.
Having climbed to above 4.0% in June/July from 3.25% in May our five year swap rates now appear set to remain solidly above 4.00% over coming years.
Long-term yields can only reverse back downwards if fixed interest investors buy aggressively in the belief that future inflation and growth will be low and the Fed will keep QE forever and a day. Very difficult to see that happening, therefore the only debate is the timing of interest rate increases and where 5-year swap rates will locate their new average levels post GFC and post QE. An average somewhere in the vicinity of 5.00% would be my view.
The interest rate market’s attention will however be focused on the short-end of the yield curve this week with the release of the June quarter’s Consumer Price Index.
Do not be persuaded by the arguments that as inflation results have been lower than forecast over recent quarters and the annual rate of 0.8% is below the 1% to 3% RBNZ target band the RBNZ will be hesitant about increasing the OCR. That is a very short term view and one prone to abrupt change when the following storm clouds on the inflation horizon are viewed:
· Tradable inflation (imported goods) is set to increase with the Kiwi dollar now trading below 0.8000. The decrease in tradable inflation that has disguised sticky non-tradable inflation over recent years due to the high currency value has come to an end. It takes six to none months for importer’s currency hedging to run through, therefore look for increases in tradable inflation in the December 2013 and March 2014 quarters.
· House building costs and rents are only going one way over the next 12 months.
· Petrol pump prices are being double-whammied by rising crude oil prices and a lower NZ dollar value.
· Food prices will also be moving higher due to the lower NZ dollar value (think imported bananas) and dairy products remaining at elevated levels.
· Capacity utilisation in the economy is well above 90.0% and there is a strong historical correlation between capacity utilisation and non-tradable inflation (domestic prices unrelated to the exchange rate), Refer chart below.
I just hope the RBNZ econometric model is accurately forecasting the clear increases in both tradable and non-tradable inflation over the next 12 months.
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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
6 Comments
Roger , I have no emperical evidence , but I think we are already in an inflationary - up cycle .
I have had a good experience with cheap borrowed money in the past 30 months where inflation ( supposedly benign ) has been very helpful , as I describe below. It cant last forever .
I feel the CPI basket on which inflation is measured is not fully representative of household expenses and outgoings, especially mortgage costs.
The strong Kiwi $ has also been masking inflationary drivers , just look at the price of oil . Petrol wuld be near $3 / litre if we did not have such a strong currency masking the symptom
A little telltale sign of underlying inflation, is when demand for houses surges, it usually means that interest rates are lower than" real " inflation, so your mortgage is inflated away as it were .
I think its cheaper to be indebted to own a home right now , because interest rates are so low that its cheaper to pay a mortgage than pay rent to a landlord .
I borrowed on my mortgage to buy some shares in 2010 and my increased mortgage costs have been taken care of by inflation in the value of my home , and my my shares have increased in capital value way over the total cost of borrowings , and the dividend yield of 7- 8% on historical cost is servicing the mortgage borrowing costs comfortably
Its almost too good to be true , but I suspect its not going to last when this Ferris Wheel, oiled by cheap money , seizes up
So the RB did nothing at 0.9%, so we'll wait, but we'd like to put it up....now its down to 0.7%....so we'll wait but we really want to put it up. At this trend we'll be 0.1% negative in about a year...and then what? bit late...
Thing about this inflation "risk" when it does actually materialise the fix can be fast and on target. ie its easy to put up the OCR up fast and as fast as you want, 100 basis points? yep no problems, every 6 weels? yep no problem. What isnt easy to stop is this trend and even deflation....sure we can drop the OCR 100basis points, but if there is no commercial investor willing to lend at such a low rate...oh dear...
Sure capacity might be being in-filled, but where are the wage rises? dropping un-employment? surely both these need to show signs of movement and will do so before we get inflation? pre-cursors?
regards
sure we can drop the OCR 100basis points, but if there is no commercial investor willing to lend at such a low rate...oh dear...
It's a case of those with equity not committing to borrow against it for a business proposition when the expectation is for lower interest rates. Hence there is no demand for goods or services associated with business ventures. If the authorities were to take the metaphorical brake off the OCR and let it represent the underlying risk businessmen would jump to secure borrowings believing further rates rises would ensue as demand for goods rose.
The US bond market is pricing in a future environment of eventual higher inflation, higher growth and high short-term interest rates and will continue to do so.
Got a time frame on the rise to higher short term interest rates?
As Bernanke said last week: “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”
negative demand-driven inflation.
Deflation is the more serious risk.
The only price hikes are from external sources beyond our control/beyond the RBNZ control.
The consumer is still very reluctant. Businesses are reluctant to borrow money to produce goods & services that consumers are reluctant to buy.
"The US bond market is pricing in a future environment of eventual higher inflation, higher growth and high short-term interest rates and will continue to do so."
Hi George
Although I share your view of inflation risk, the market is not agreeing with us at this stage. Did you look at US TIPs break even inflation? By my reckoning 30 year break even inflation (implied by the difference in yield of a nominal vs a TIPs 30 year bond) has actually fallen since the June sell-off.
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