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NZ: Outlook for the 3Y NZGB/ACGB spread

Data Flash (New Zealand)
NZ: Outlook for the 3Y NZGB/ACGB spread

Summary

We first recommended buying 3Y NZGBs against 3Y ACGBs on 7 March and reaffirmed our view in early April. Between our first recommendation and now the 3Y NZGB/ACGB spread has narrowed from 100 bp to 72 bp.

The stance of the RBNZ and RBA seem to have converged to an "on hold" status. While this stance will change if there are any further disappointments about the global outlook, the easing cycle seems to be drawing to a close. With domestic demand in NZ holding up well, the prospect for further outperformance is receding.

We think it is time to take profit on the 3Y NZGB/ACGB trade at current spreads.

The 3Y NZGB/ACGB spread has converged as the economic performance "gap" has narrowed

The recent fall in NZ business confidence has narrowed the gap that had opened up between Australia and New Zealand. By just how much depends to some degree on the NZ survey chosen, with the quarterly NZIER survey showing a much larger decline than the National Bank survey. The chart below measures the "gap" using the monthly survey. We suspect the next quarterly NZIER survey (for June) will show something of a rebound back closer to the level of the monthly survey.

The 3Y spread is already anticipating a further narrowing in the performance gap

The 3Y NZGB/ACGB spread has declined from around 100 bp in early March to its present level of around 70 bp. This is actually a greater decline than the narrowing in the "confidence gap" seen to date would imply. The market seems to be anticipating a further narrowing of the performance gap between the NZ and Australian economies.

We think this narrowing will take place. For instance, the Australian economy will likely be boosted by a recovery in the housing market from very depressed levels in the coming months. At the very least, housing will not be the large source of negative growth it proved to be in the second half of 2000.

However, as noted, this already seems to be priced in. We believe that significant outperformance by the NZ bond market from this point will require an expectation that the present 75 bp differential between the OCR and RBA cash rate will narrow. While we don't rule out additional rate cuts by either central bank, we think these will likely happen if the global economy weakens further rather than be triggered by domestic concerns. In which case it is likely that both the RBNZ and RBA will ease. Certainly, it is difficult seeing the RBNZ easing on domestic concerns when retail sales remain robust, the housing market is picking up and inflation is already close to the top of the target band. Thus, we would be surprised to see the gap between the OCR and the RBA cash rate narrow beyond its present level of 75 bp.

Having said this, with the gap between NZD and AUD Sept and Dec 2001 bills presently more than 80 bp there is some scope for a modest narrowing of the interest rate differential. Still, this hardly looks attractive given recent volatility in spreads. We think the bulk of the 3Y NBZGB/ACGB spread compression is complete.

David Plank Fixed Income Strategist (612) 9258 1475


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