NZ: Outlook For The 3Y NZGB/ACGB Spread
Data Flash (New Zealand)
The widening in the 3Y NZGB/ACGB spread has been driven by the widening in the cash rate differential. In turn, this widening has been driven by the recent divergence in economic performance. This is captured in the "confidence gap". We doubt there is much scope for the confidence gap to widen dramatically from current levels. Indeed, there is likely to be some narrowing of the gap in the months ahead. This suggests we are at a point where NZ short bonds offer value against Australia.
The optimal way to put the trade in place is to receive 3Y NZD swap and sell the 3Y AUD future.
Economic divergence in NZ and Australia sees cash rates diverge
Note: For Australia, NAB business conditions are used rather than expectations. There has been a significant divergence in the performance of the NZ and Australian economies over the past 12 months. This is evident in the divergent shifts in business confidence. NZ business confidence suffered a sharp downturn in the first half of 2000 as businesses reacted negatively to a series of policy changes by the new Labour/Alliance Government and RBNZ rate hikes. Confidence has since recovered. In contrast, Australian business confidence held up in the first half of 2000, before falling sharply in the second half of the year. Confidence has remained weak in early 2001.
The divergence in business sentiment is consistent with the recent divergence in monetary policy settings. The RBA has eased 75 bp since the start of the year, taking the cash rate to 5.5%. In contrast, the RBNZ has kept its OCR at 6.5% and seems likely to leave the rate unchanged next week.
While it has not always been a reliable indicator of movements in the 3Y spread, perhaps because prior to 1999 NZ's monetary policy regime meant that movements in interest rates were not always consistent with the economic data, the "confidence gap" has been a good forward predictor of shifts in this spread over the past 12 months.
This relationship suggests that unless the confidence gap continues to grow the widening in the 3Y NZGB/ACGB spread is largely complete.
Of course, a further widening in the confidence gap cannot be ruled out. For example, in February 1999 the gap was more than 60 points as the National Bank's measure of NZ confidence rose to more than 60%.
It would seem unlikely, however, that NZ confidence can continue to rise sharply in the face of the slowing global economy. While the low value of the NZ dollar and the fact interest rates have been on hold (rather than rising) have been important factors in boosting confidence, a further boost from these sources at the same time as the global outlook is becoming more uncertain seems difficult to achieve.
A major move higher in the confidence gap from this point will likely require a further retreat in Australian sentiment that is not accompanied by a fall in NZ confidence. A fall in Australian sentiment is certainly possible. The NAB business conditions index has further to fall if the Australian economy is in recession, and this can't be ruled out given the tone of the recent activity data such as ANZ job ads.
The key issue is whether NZ business confidence can remain strong if the Australian economy falls into recession. With some 20% of NZ exports flowing to Australia, including close to 50% of manufactured exports, we think not. Thus, we are confident that the widening in the confidence gap is close to an end. In any event, it is worth noting that a confidence gap of 60 points seems consistent a 3Y spread of around 110 bp. This is not much wider than the present spread.
Rather, the risks seem increasingly weighted toward a narrowing in the confidence gap. Further rate cuts from the RBA should limit the downside in Australian confidence and eventually lead to a bounce. We also think NZ confidence is at risk of turning, though the present momentum in the economy suggests a significant fall in confidence is unlikely for a while yet. All up this suggests it is time to start considering going long NZ short bonds against Australia. Below we consider the optimal way to put such a trade in place.
Receive NZ 3Y swap, sell AUD 3Y futures
In our view, the optimal way to benefit from the likely contraction in the 3Y spread between NZD and AUD yields is to receive 3Y NZD swaps and sell the 3Y Australian bond future. This relies on the following factors:
We are of the view that asset swap spreads are likely to contract further in Australia and New Zealand. There remains a large positive carry provided by swap spreads since the value of collateral has consistently fallen in both New Zealand and Australian markets.
The 3Y AUD future remains expensive to the bonds in the basket. The implied repo on the June 3Y AUD future is 5.42% whereas GC for 15 June 01 is 5.30% bid. As a consequence, receiving 3Y NZD swap and selling the 3Y AUD June contract has a positive carry of 50 bp over a 3M horizon. Hence, the break-even on the spread is 5 bp larger than the current 147 bp spread.
Finally, the spread is at attractive levels as shown below.
David Plank, FI Strategy 649 351 1490 Jean Dumas, FI Relative Value 612 9258 1455