Outlook for the NZ Yield Curve - January 2002
Data Flash (New Zealand)
The OCR has now been through a full cycle. This allows us to plot the yield curve against the cash rate and we find there is a strong link between the two. If the easing cycle is over, then we are likely to see a flatter yield curve going forward. With only a modest amount of flattening priced into the curve, the negative carry associated with flattening trades should not be a major issue.
One thing that could be an issue is our belief that the bond market offers near term value. We find a reasonable inverse relationship between the curve and bond yields. Yet, because we see any NZGB gains from this point being driven more by a rally in the US long end than by domestic considerations this should not, in our view, be a problem.
We recommend that investors position for a flatter NZGB curve over the next 12 months.
The yield curve versus the cash rate
One of our favoured ways of looking at the shape of yield curves across the $-bloc is against official interest rates. Until the introduction of the Official Cash Rate (OCR) by the RBNZ in early 1999, this wasn't possible in NZ. Rather, one had to look at the 3M rate. While this proved a useful tool against which to measure the "appropriateness" of the slope of the yield curve at any point in time, it was difficult to predict the future path for the 3M rate given its volatility as a consequence of the MCI framework.
The OCR has now been in place for a complete cycle. This allows us to plot the OCR against the 3Y/10Y NZGB spread to see whether we get a similar relationship to that which exists in Canada and Australia. It appears that we do, with the slope of the yield curve closely related to the level of the cash rate.
If the RBNZ's easing cycle is over, which is our central view at this stage, then the curve is likely to flatten from this point forward.
One problem with flattening trades is that they typically have negative carry. This is not presently a major issue in New Zealand, with the 6 month forward Feb 05/Apr 13 NZGB spread only 10 bp narrower than the spot spread of around 80 bp.
A bigger issue in the near term may be the link between the curve and the level of interest rates. Since we think the US has too much tightening priced in, we are modestly bullish on the outlook for yields at this point. Below we consider how a bullish near term outlook might impact on the NZ yield curve.
The link between the yield curve and the level of interest rates
The chart below plots the yield curve against the 3Y NZGB yield. Not surprisingly given the link between the cash rate and curve, it shows a strong inverse relationship. That is, the curve typically steepens when yields rally and flattens when the market sells off.
On the face of it, this should make us wary about recommending flattening trades at this point given our belief that the market is likely to rally in sympathy with the US. Yet, the very fact we think the US long end offers value at this point might actually be supportive of NZGB curve flattening.
We are looking for the NZ long end to be dragged lower by gains in USTs as the market reconsiders the likely speed of the Fed tightening rather than rally for domestic reasons. In contrast to what is priced into the Eurodollar strip, the 100 bp of tightening priced into the Dec 02 NZD bills does not look overly excessive at this point in the cycle. Thus, our near term outlook for long bond yields may actually support a flatter curve before the expectation of higher cash rates becomes the driving force.
As such, we recommend that investors begin to position for a flatter NZGB yield curve.