Will The RBNZ Tighten If The Fed Is Easing
Data Flash (New Zealand) Will The RBNZ Tighten If The Fed Is Easing
On a recent sales trip to Asia, many investors made it clear that they considered it very unlikely that the RBNZ could tighten in 2001. While the recent weakness in the NZ economy was a factor in this view, the critical influence was the belief by many that the global economy was slowing and that the Fed would be easing.
It is not unprecedented for the RBNZ to be in tightening mode while the Fed is easing - though the absence of an official interest rate for most of the 1990s complicates the determination of the RBNZ's stance at any point in time.
We certainly don't see an easing stance by the Fed as ruling out a tightening move by the RBNZ. However, it will influence the market's reaction to the move.
We think the RBNZ will most likely tighten in the first half of next year. This should lead to further inversion of the NZ curve and some modest widening in the 10Y NZGB/UST spread. We would be short NZD bills and 2Y bonds on an outright basis at current levels.
With credit conditions tightening, equity markets under pressure and the data showing increasing signs of a US slowdown the market has become more comfortable with pricing in a Fed easing in the first half of next year. Arguably the extent to which short bonds have pushed through cash means the market is actually looking for a sustained easing in policy by the Fed.
At the same time the NZ market has reduced its expectations of a tightening by the RBNZ to the extent that only perhaps a 50% chance is assigned to a 25 bp tightening in the first half of next year. Despite this, a number of NZ analysts expect the RBNZ to tighten at least 50 bp next year.
On a recent sales trip to Asia, investors generally expressed surprise at the contention that the RBNZ could tighten in 2001. This reflected both the present weakness of the NZ economy and the widely held view that the global economy was slowing and that the Fed could be easing within 6 months or so.
The RBNZ and the Fed
Examining the history of the RBNZ versus the Fed is complicated by the fact the RBNZ did not use an official cash rate to set monetary policy until March 1999. Using the 90 day bank bill rate as a proxy for RBNZ monetary policy settings causes difficulties because there were a number of occasions, most notably in 1998, when short term interest rates went in the opposite direction intended by the stance of monetary policy because of the behaviour of the currency. In the chart below the RBNZ's Monetary Conditions Index is used as the proxy for the “intent” of the RBNZ's monetary settings, even though this index was only explicitly used by the RBNZ for a short period. Unfortunately, even this proxy measure has difficulties as discussed below.
It is immediate apparent from the chart that it is not unprecedented for the RBNZ to be in tightening mode even if the Fed is easing. The Fed easing that began in July 1995 was not followed by the RBNZ. While the MCI went sideways for a period and the RBNZ considered adopting an easing stance in October 1995, the Bank became increasingly hawkish in late 1995 and early 1996 as the labour market tightened and the inflation outlook deteriorated.
It would also appear from the above chart that the RBNZ is prepared to ease aggressively while the Fed is tightening. However, unlike the rise in 1995/96, the plunge in the MCI during 2000 does not accurately reflect the RBNZ's stance. The Bank has actually raised the OCR this year, but the plunge in the currency has more than offset this in MCI terms.
It's inflation, stupid
With apologies to Bill Clinton, it is the inflation outlook that drives the RBNZ's setting for monetary policy. Naturally, the level of activity and its rate of growth are important inputs into the determination of the inflation outlook. However, a slowdown in activity is neither a sufficient or necessary condition for an easing in monetary policy. To demonstrate this, the chart below shows that while growth slowed significantly in 1995 and 1996 the RBNZ still adopted a hawkish stance over this period.
Of course, that hawkish stance contributed to the poor performance of the NZ economy in 1997 and 1998. Arguably the RBNZ may have learnt from that experience and is more forward looking this time around. While we indeed think this will be the case, the pressures on inflation are such that we still believe the RBNZ will tighten further. Even if the cash rate gets to somewhere between 7-7.5%, it will be some 200 bp below the level prevailing for much of the 1995-97 period while at the same time the NZD will be at very stimulatory levels.
It is also worth noting that NZ growth in 2001 is generally expected to accelerate from the pace recorded in 2000. While the level of activity is unlikely to be sufficient to put significant pressure on capacity, we expect it to be robust enough to lessen concerns that a further tightening will lead to an economic collapse. It is also important to recall that the price pressures facing the NZ economy as the result of the low NZD are almost the mirror image of those facing the US. While the RBNZ will look through the first round effects of currency weakness, the likelihood of second round effects increases as the economy recovers and the longer the headline inflation rate remains above 3%.
Will NZ growth hold up if the US slows?
While it is true that the inflation outlook is the key to assessing the RBNZ's likely policy stance, the possibility of a sharp slowdown in the US economy could give the RBNZ reason to pause. As we have seen, the prospect of a modest US slowdown and a mild Fed easing cycle is unlikely to be enough to prompt this. Indeed, a US slowdown to around 3% over 2001 is already factored into the RBNZ's forecasts. However, a US hard landing will prompt a change in the RBNZ's outlook
The above chart suggests NZ will not be able to avoid a negative impact from a sharp slowdown in the US economy. The US recessions in the early 1980s and 1990s were matched by recessions in NZ. Though the NZ economy has been out of sync with the US economy in the past few years, there are identifiable reasons for this (the Asian crisis, RBNZ policy errors and the impact of the Labour/Alliance Government on business sentiment). A sharp US slowdown will almost certainly lead to weakness elsewhere in the globe and provide a significant offset to the stimulatory impact of the low NZD.
The judgement call for the RBNZ to make is whether the prospects for a US hard landing are sufficiently high to offset the concern about the level of inflation pressure in the economy. At this stage we think not.
How will the market react to an RBNZ tightening?
As discussed above, many international investors believe the prospect of a tightening by the RBNZ is very remote. The overall market does as well, with less than one 25 bp tightening priced into the first half of 2001. While these expectations may change ahead of any RBNZ move (the Bank may certainly attempt to “influence” expectations before it moves), the perceived credibility of the tightening will be an important determinant of the market's reaction.
One would “normally” expect a tightening in NZ to lead to a widening in interest rate differentials across the curve. For instance, given the range the 10Y NZGB/UST spread has traded this year the expectation of a widening in the cash rate differential to 100 bp (perhaps through the combination of RBNZ rate hikes and Fed rate cuts) might be expected to lead to a 10Y spread of +125 bp. At the same time, wider interest rate differentials might be expected to favour the NZD.
However, as has been the case for much of this year, central bank tightenings don't always produce the expected market reaction. An important issue is the market's view about the sustainability of the move. If the tightening is seen as a “mistake” that might be quickly reversed then the currency could come under pressure and the bond spread even contract.
The credibility of any RBNZ tightening will, of course, depend on the data between now and any move by the Bank. The pick-up in business and consumer confidence in the most recent surveys will give the Bank some confidence to go ahead and tighten. However, if the global environment continues to be uncertain investors are likely to see any RBNZ move as temporary. While that will remain to be seen, it will certainly add to the pressure for the yield curve to flatten/invert.
At this stage we recommend investors position themselves for further curve flattening/inversion and a widening in the 10Y NZGB/UST spread. We also think the front end of the NZ curve is expensive and would be outright short the March and June 2001 bill contracts and the 2Y NZGB.
David Plank, Fixed Income Strategist (649) 351 1490
This, along with an extensive range of other publications, is available on our web site http://research.gm.db.com
In order to read our research you will require the Adobe Acrobat Reader which can be obtained from their website http://www.adobe.com for free.