Outlook For The NZ Bond Market In Q4
Data Flash (New Zealand)
The direction of the US market is likely to be the key to the outlook for the NZ market. With lots of good news priced into the US market, we suspect yields will continue to be trapped in a fairly narrow range.
While the RBNZ may eventually tighten, the
tone of the activity data over the next few months suggests
there will be little pressure on the NZ market
to price in more tightening than is already built into the bill strip unless evidence of second round effects emerge. Unless the eurodollar strip begins to build in even more easing, there will be little pressure on the 10Y NZGB/UST spread to widen. Indeed, if the NZD can stabilise then the spread may narrow.
Given our outlook for US yields and the 10Y NZGB/UST spread, the NZ yield curve should remain fairly flat. Introduction
As is always the case in examining the outlook for the NZ bond market, the real key is the direction of US long bond yields. Having determined this, the next step is to consider the likely relative performance of the NZ bond market. The key determinant of this will be expectations regarding the future gap between official interest rates in NZ and those in the US. Other factors will also have an impact, but our research continues to show this expectation "gap" will have the biggest influence.
The rest of this note follows this basic outline. First we examine the prospects for the US market. Second, we consider the outlook for NZ and US monetary policy relative to what is already priced into the bill and eurodollar strips and determine the implications for the relative performance of the NZ bond market. Finally, we pull the analysis together and consider the outlook for NZ bond yields and the shape of the curve.
The outlook for the US bond market in Q4
In the past decade the daily correlation between 10Y UST and 10Y NZGB yields has been more than 90%. In 2000 this correlation has actually increased to more than 93%. It is true to say that, in terms of direction, where the US market goes so does NZ.
We have little reason not to expect the correlation between the NZ and US markets to remain high. Determining the direction of the US bond market will remain the key to determining the outright direction of NZ bond yields. It is fair to say that at this point in time the outlook for the US bond market is particularly uncertain. Recent corporate earning downgrades (Intel, Eastman Kodak, Apple etc) hint that the prospect of a slowdown in the US economy may be greater than consensus forecasts suggest. However, there is already a lot of good news built into the US bond market. The outlook for oil prices is also an issue. If higher oil prices have acted as a tax on growth, will lower prices be like a tax cut (if prices do in fact decline)?
Given what is already priced into the US market (for instance the March eurodollar contract is already looking for an easing in Fed policy), our assessment for US bond yields over the course of Q4 is that continued range trading is the most likely outcome. Between June and the end of September, 10Y UST yields have traded between 5.68% and 6.20%. We think yields will continue to be contained within this range, with the downside more likely to be tested than the topside.
The outlook for US and NZ monetary policy in Q4
Our US economics team believes the Fed is on hold for the foreseeable future. While the Fed has decided to retain its policy bias toward tightening, an increase in the Fed funds rate seems very unlikely this year given the tone of the recent data. Indeed, it is possible that the Fed may move to a neutral bias at the end of this year and an eventual easing in policy sometime next year is a real possibility.
The market certainly thinks so. The March eurodollar contract is effectively pricing in a 25 bp easing. This seems a bit early. While the US data such as the NAPM point to a slowdown in activity, the pressure on capacity is such that an easing in monetary policy looks unlikely for a while yet. This suggests that the near term scope for the eurodollar strip to get more bullish on the outlook for rates is reasonably limited - unless (as always) the equity market suffers a major correction.
This suggests that over the next few months at least the gap between NZ and US monetary policy expectations will be driven by shifts in the outlook for NZ interest rates.
On its own the soft NZ activity data, with GDP falling in Q2 as business and consumer confidence plummeted, would indicate there is little prospect of the RBNZ tightening in the near term. However, the weakness of the NZ dollar and higher commodity prices (not just oil) mean that the inflation outlook has deteriorated significantly. We believe inflation is set to rise above 3% by year end and remain there for all of 2001.
The combination of weak growth and rising inflation creates a difficult environment for the RBNZ. It is important at this point to emphasise that the difficulty is not caused by uncertainty over the policy decision tree: if second round inflation effects are expected then the RBNZ will tighten policy. Dr Brash made this clear in his speech to FEC. The difficult judgment is whether second round effects are likely given the weakness of the economy.
Thankfully, to determine the likely relative performance of the NZ bond market, the judgment we have to make is not whether the RBNZ will in fact tighten but whether the degree of tightening already priced in by the market is likely to be too much or too little. Since the NZ market is looking for 75 bp of tightening over the next 12 months, this call looks somewhat easier to make. While the RBNZ may ultimately take the cash rate above 7%, it is difficult to see the market in the next few months pricing in any more tightening than is already built in.
Once the Q3 CPI is out of the way on 16 October, we see few pressures for the bill/eurodollar gap to widen significantly from current levels. If this is correct then there will be little pressure on the 10Y NZGB/UST spread to widen from present levels. Indeed, IF the NZD can stabilise (and admittedly that's a pretty big if) then there is some prospect of the 10Y NZGB/UST spread contracting as the NZ market winds back some of the tightening priced in.
The key issue for the NZ bond market, or any in the $-bloc for that matter, is the direction of US yields. Domestic considerations are generally of second order importance and determine the relative performance of NZ rather than absolute direction.
While there are clear signs that the US economy is slowing and that the Fed is therefore unlikely to tighten, there is already a great deal of bond friendly news built into the US market. This suggests a continuation of the range trade behaviour seen for much of this year.
If so then NZ yields will also range trade. Over the course of this year we'd be surprised to see 10Y NZGB yields above 7% and see levels close to this as a good opportunity to extend duration. Toward 6.5% we prefer to be sellers.
The 10Y NZGB/UST spread also seems set to range trade for the rest of the year. Above +100 bp we think there is value in NZ bonds, while we would be sellers of NZ below +75 bp at this stage.
The yield curve will depend in part on the NZD. However, if our view on the US is right then there will be little pressure on the curve to steepen significantly and some pressure to flatten if the NZD remains under pressure.
David Plank, Fixed Income Strategist (649) 351 1490
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