Outlook for NZ Yield Curve
Data Flash (New Zealand) NZ:
Outlook for NZ Yield Curve
The widening in the 3Y/10Y NZGB spread anticipates a recovery in NZ's annual rate of growth over the second half of the year. However, with question marks emerging over the pace of global growth there must be some prospect this does not take place.
As a consequence we don't believe that further widening in the 3Y/10Y spread will happen in a linear fashion. The greatest scope for steepening now appears to be between bills and short bonds.
We also think the NZ curve will become more concave over time, thus favouring butterfly trades. We intend to look into this issue further.
The yield curve has "normalised" since the RBNZ's first rate cut
The NZ yield curve has taken on a "normal" shape in the past 6 weeks, with the inversion between cash/bills and bonds that had got underway in November 2000, and then intensified as the move to an easing bias by the Fed pushed bond yields lower, disappearing.
In the following we look at the factors driving the NZ yield curve and what the outlook is from here.
The NZ yield curve over the past decade
The chart below shows that relative to history, the current 3M/10Y spread is still quite modest. However, at around +60 bp the 3Y/10Y spread has already reached levels that have only occasionally been exceeded in the past decade.
A few months back we noted that while the volatility in short term interest rates before 1999 may make comparisons of the 3M/10Y spread across time relatively meaningless, this might be less of a problem for the 3Y/10Y spread. Certainly, our analysis indicated 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. The chart we looked at then is repeated below.
The steepening of the NZ yield curve since the beginning of the year points to an acceleration in annual rate of growth. Of course, with last year's negative June quarter soon to drop out, an acceleration in the annual growth rate to match the steepening of the curve that has already taken place is almost a mathematical certainty.
The key issue is what direction will the curve take from here. The above chart suggests this will depend on what shape (V, U or L) the recovery takes. At the moment the market seems to be betting on a V.
Continued faith in V-shaped recovery key to further 3Y1/10Y steepening
The chart above linking GDP growth and the yield curve suggests that the key to further steepening is faith that the NZ economy will enjoy robust growth over the second half of 2001 and into the following year. As an example of this, note that the "failure" of the recovery in late 1996 to kick on into 1997 was associated with a reversal of the steepening that had been underway since mid-1996.
To the extent that additional rate cuts from the RBNZ are required to ensure a continued recovery, the steepening will likely be more pronounced than otherwise.
We certainly expect the RBNZ to cut rates further as the Fed continues to ease. Our expectation that the RBA will also ease again will place additional pressure on the RBNZ to eventually follow suit.
We are less certain, however, that the recovery will be as V-shaped as the market expects. Or, perhaps more correctly, there is a good chance the bottom of the V proves to be deeper than the market expects.
While this doesn't rule out further bull steepening, the historical experience would perhaps inject a note of caution into expecting further curve steepening between short and long bonds from this point to happen in a linear fashion.
The influence of the US curve on the NZ curve
In thinking about the prospects for the NZ curve, one important influence that must be considered is the US market.
We have previously looked at this issue and shown that movements in the US curve driven by the long end have a higher correlation with movements in the NZ curve than when the US curve is driven by the front end. This reflects the very high correlation between long bond yields in the US and in NZ.
The higher than usual correlation between the US and NZ yield curves evident since the beginning of 2000 is, in large part, due to the fact the US long end has been a prime drive of curve shape over this period. The fact the RBNZ has followed the Fed in easing has facilitated the correlation between the two yield curves since the beginning of 2001.
The US 2Y/10Y spread is now at its widest for some 7 years. As a result, our US strategy team believes the appeal of 2Y/10Y steepening trades has lessened to the point where they have recommended that leveraged traders take profit on such trades. Consistent with this, they are also looking for a rally in the US long end to take 10Y yields back below 5%. Such a view is consistent with expectation that the NZ 3Y/10Y spread will not widen in a linear fashion from this point.
Rather, we now think the part of the NZ curve that presents the greatest opportunity for steepening is between bills and short bonds.
We also think the NZ curve is likely to become more concave over the medium term as we approach the end of the easing cycle. This suggests that butterfly trades may hold some appeal. We are going to consider this issue in greater depth in later research.
David Plank, Fixed Income Strategist
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