Looking At The Value Of NZ Short Bonds
Data Flash (New Zealand)
NZ is the first market in the $-bloc to give up on the prospect of further rate cuts. This raises the issue of whether there is absolute and/or relative value in the front end of the NZ bond market.
We find that 3Y NZGBs appear to offer value relative to NZD bills and 3Y ACGBs. We note there is considerable event risk around these trades over the next few weeks. With the Eurodollar strip still too steep, in our view, we cannot reach the same conclusion relative to USTs.
The issue of whether NZ short bonds offer value on an absolute basis ultimately comes down to whether the market is right to assume the RBNZ has finished easing. While this conclusion might be premature, we think the balance of evidence points to the RBNZ being on hold for a period until it begins tightening in the second half of the year. From a trading perspective this makes us wary about being outright long.
The cash rate and short bonds The NZD bill strip has given up on the prospect of further rate cuts. The market has done so because of the high easing hurdle set by the RBNZ and the resilience of the domestic economic data. As well, while the US data have not been robust enough to justify the rate hikes priced into the Eurodollar strip the numbers have shown some signs of stabilising. In its November statement the RBNZ made it clear that in the absence of a domestic slowdown, the global data would have to deteriorate further for the Bank to ease again.
With the rest of the $-bloc markets still looking for rate cuts, it is interesting to see whether the NZ front end offers value in both outright and relative terms. Our starting point is to consider the link between the cash rate and short bonds.
The following chart shows the spread between the 3Y NZGB and the 1st bill contract, with the cash rate plotted against the right hand axis. This chart suggests that based on the historical experience the gap between the 3Y bond and the bills is close to its likely maximum. What's more, looking further out the gap between the 2nd bill contract and the 3Y NZGB is close to its widest level since the OCR was introduced in early 1999.
Of course, this does not necessarily mean the 3Y NZGB is cheap on an outright basis. For instance, we have argued in recent research that the NZD bill strip may be too flat if the easing cycle is at an end. Thus, the gap between the bills and 3Y could narrow via weakness in the bills rather than gains by the 3Y.
Whether 3Y NZGBs represent value on an outright basis is ultimately a question of whether the market is correct in believing the RBNZ has finished easing. Our NZ economists believe the Bank has most likely finished easing, with rate hikes possible in the second half of the year as evidence of a global economic recovery accumulates. We are not inclined to be outright long 3Y NZGBs from a trading perspective in light of this.
Still, at least relative to bills the 3Y NZGB appears to offer reasonable value. One possible trade is to buy the Feb 05 NZGB and sell the June 02 bill contract at the present spread of 88 bp. We recommend putting this trade in place before the RBNZ statement next week.
3Y NZGBs relative to USTs and ACGBs
In looking at the relative value of short bonds across the peripheral $-bloc markets, our primary focus are the expectations for relative monetary policy settings. Our analysis suggests that 3Y spreads rarely diverge substantially from the relative monetary policy settings priced into the futures strips. This is evident in the following chart, which compares the 3Y NZGB/UST spread against the gap between the 2nd Eurodollar and NZD bill contracts.
In our view the relative performance of the NZ and US economies will not support a long term OCR/Fed funds gap of more than 250 bp. Yet given how close the 3Y spread tracks the near term Eurodollar/bill spread this consideration may not be all that relevant. Our US economists believe that the US recovery will not justify the rate hikes priced into the Eurodollar strip for 2002. In contrast, the slope of the NZD bill strip does not look as extreme as that for Eurodollars. Thus, we don't think there is a strong case in the near term for buying short dated NZGBs against USTs. Of course, if you have the view that the US market is expensive and the data will surprise on the strong side then NZGBs might appeal as a defensive trade.
The relationship between the 3Y NZGB/ACGB spread and the gap between the NZD and AUD bill strips is very similar to that for the US. On this basis, the Feb 2005 NZGB/Sept 2004 ACGB spread of more than 100 bp looks too wide relative to the June NZD/AUD bill spread of around 85 bp. Even if the RBA delivers the rate cut priced into the bill strip (which, in our view, is not assured), we believe the NZD/AUD June bill spread is unlikely to widen much beyond 100 bp.
Interestingly, you don't reach the same conclusion about the "excessive" width of the NZGB/ACGB spread if you compare the Feb 05 NZGB with the Jul 05 ACGB. The gap between these two bonds is within a few basis points of the bill spread.
>From the chart above it is evident that the Sept 04 ACGB richened considerably during December. Over this period the Sept 04s were tightly held and traded special on repo. This may now be in the process of unwinding. We note, however, that the Sept 04 will tend to become the bond of choice for short dated asset books - especially if the RBA is seen as keeping the cash rate unchanged for an extended period. Still, at this stage we think the premium in the Feb 2005 NZGB more than compensates for this risk. We recommend buying the Feb 2005 NZGB and selling the Sept 2004 ACGB - though we would wait until after the publication of the Australian employment data on Thursday before putting the trade in place.
David Plank, Fixed Income Strategist