Outlook for NZ Yield Curve - 20 February 2001
Data Flash (New Zealand)
Outlook for NZ Yield Curve - 20 February 2001
Summary While the NZ yield curve remains inverted between cash and bonds, it has normalised between short and long bonds. The shift in the 3Y/10Y spread looks consistent with the acceleration in annual GDP growth that will occur when last year's negative June quarter falls out of the figures.
The near term influences on the yield curve suggest, on balance, some modest flattening. The RBNZ will not deliver the easing priced into the market and we expect the US long end to rally modestly from here.
However, over the medium term the expected rebound in global activity in the second half of the year should prompt a steeper yield curve.
Following the RBNZ statement in August of last year, we published a note that argued that strong domestic data and an increasingly hawkish RBNZ would prompt the NZ yield curve to flatten/invert. This trend was expected to be assisted by trends in the US market, namely a relatively strong performance by the US long end.
In the event, the rally in the US bond market ensured that the NZ yield curve inverted significantly between 3M bills and bonds. This continues to be the case. However, since the Fed moved to an easing bias in late December the yield curve has steepened between short and long bonds. This shift mirrors that seen across the $-bloc.
In the analysis below we look at the likely influences on the NZ yield curve over the next few months. With the RBNZ unlikely to ease before May, if at all, the inversion between bills and bonds will remain. The direction of the short/long bond spread is more uncertain.
The NZ yield curve over the past decade
The chart below shows that relative to history, the current 3M/10Y and 3Y/10Y spreads are quite modest. Nor is the difference between the two sets of spreads all that great. What is unusual is the fact that the 3Y/10Y spread is positive while the 3M/10Y slope is negative. The last occasion this occurred for any length of time was in late 1996/early 1997.
One could note that the shift to a positive 3Y/10Y spread in late 1996 took place just in advance of the RBNZ's move to an easing stance in the December 1996 Monetary Policy Statement. Thus, the current situation could indicate a similar shift is thought likely. Certainly the NZ market expects an easing from the RBNZ in the near term.
One objection to comparisons of this sort is that the RBNZ's present official cash rate (OCR) regime is very different from that which operated prior to early 1999. Prior to the OCR regime there was no official cash rate, which meant there was considerable volatility in short term interest rates. While the volatility in short term interest rates before 1999 may make comparisons of the 3M/10Y spread across time relatively meaningless, this could be less of a problem for the 3Y/10Y spread. Certainly, the chart below suggests that movements in the 3Y/10Y spread prior to 1999 had some success in anticipating the evolution of economic activity. It is difficult to see any great change in this relationship since early 1999.
With the annual rate of GDP growth set to accelerate in mid-2001 as last year's negative GDP figure drops out of the reckoning, the steepening in the yield curve underway since the end of 2000 will have foreshadowed this turning point.
Near term influences on the yield curve
The US market - modest flattening influence
The high correlation between NZ and US long bonds ensures that movements in US yields can have a significant impact on the shape of the NZ yield curve. This was particularly evident in the first half of 2000, when the flattening in the US curve was driven by the rally in the US long end. During this period, the correlation between movements in the US and NZ yield curves was higher than usual.
In the near term we expect the US long end to remain volatile, reflecting the uncertain nature of the US landing and subsequent takeoff. As a consequence, the US long end will likely offer little direction for the NZ curve. If the US market does trend in a particular direction, we suspect it will be down initially on the back of weak data and struggling equities. Other things equal this will tend to flatten the NZ curve. However, this influence is likely to be relatively short lived. By the end of the year we expect 10Y UST yields to be higher than present levels.
The RBNZ - modest flattening influence
A range of domestic indicators has painted a picture of an economy that is in a different phase of the business cycle to others elsewhere. Business and consumer confidence are rebounding sharply, the unemployment rate is falling, wage pressures seem to be on the increase (if only modestly) and most inflation indicators are surprising on the strong side. But for developments in the global economy, the RBNZ would almost certainly be tightening. Despite this, the June bill futures are pricing in some 50 bp of easing.
While the weakness in the global economy will continue to support the expectation that the RBNZ will eventually ease, the market is clearly vulnerable to disappointment over the timing of any move. A rate cut in March looks to be almost out of the question, while even a move by May seems unlikely unless hopes for a reasonable second half rebound in the US economy fade significantly.
With an easing priced in, the failure of the RBNZ to deliver an easing as soon as expected will be negative for bank bill futures. This might be expected to prompt some modest flattening of the yield curve. However, while the outlook for the global economy remains so uncertain 2Y and 3Y bonds are unlikely to sell off significantly even if the RBNZ fails to endorse the easing priced in by the market. Indeed, RBNZ acknowledgement of the risks to the outlook might actually provide support for 2Y and 3Y bonds and could see the curve steepen (as in mid-January). On balance we think the RBNZ statement will have a modest flattening influence.
Conclusion - little pressure on curve to steepen in near term
In the near term we believe there is little pressure on the curve to steepen further. Indeed, the balance of risks would seem to point toward some modest flattening as we move closer to the RBNZ's Monetary Policy Statement. A near term steepening from this point would most likely require weakness in the US long end.
Medium term influences on the yield curve
The evolution of the growth and inflation outlook, both here and offshore, will be the most important determinant of curve shape over the medium term. The chart above implies that while the outlook points to a rebound in activity the NZ curve will tend to steepen. At this stage a second half rebound in global growth and a continued acceleration in NZ activity is our favoured scenario. Thus, while there may be some short term pressure for the NZ yield curve to flatten, the medium term outlook is for further steepening.
David Plank, Fixed Income Strategist
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