Too soon to buy the NZ front end
Data Flash (New Zealand) Too soon to buy the NZ front end
The NZ bill strip is already factoring in an OCR above 7% by the second half of 2003. This looks excessive when one considers the peak in the last tightening cycle (6.5%) and the extra indebtedness of NZ households.
A rising NZD might also constrain the eventual level of tightening by the RBNZ. Yet there are factors at work that suggest the RBNZ may be facing a more robust economy now than in 2000. Business has learnt to live with the Labour/Alliance Government, net migration inflows are back to the levels seen in the mid-1990s and the economy looks closer to full capacity now than in 2000.
In any event, history suggests that there is little upside in buying the NZ front end ahead of the first rate hike - especially against a backdrop of an improving global economy. Having said this, we do think the market is looking for the first rate hike too soon. We believe this supports being long very short term physical paper now and possibly buying the June bills ahead of the RBNZ meeting (since the March bills will have expired).
NZ front end prices in yet more tightening With the March 02 3M bill contract trading around 94.90, or some 35 bp above cash, the NZ market is now looking for the RBNZ to tighten as early as its April meeting. What's more, the market believes the cash rate will be above 6% by the end of the year. From that point the market prices yet more tightening, with the Official Cash Rate (OCR) seen rising above 7% by the second half of 2003.
This is above the peak level set by the OCR since its introduction in March 1999. In the 2000 tightening cycle the OCR reached 6.5%. While it is always difficult to ascribe cause and effect, this appeared to be sufficient to slow the domestic economy. For instance, the chart above shows that the rising cash rate in 2000 preceded a slowdown in retail sales.
More generally, overall GDP growth slowed sharply during 2000. This was despite the strong global economy and the offset to higher interest rates provided by the falling NZD.
The economy may be more robust than during the last tightening cycle On the face of it, this would suggest the market's pricing for the eventual peak in the cash rate is excessive. After all, given the increase in household indebtedness since the last tightening cycle the impact of higher interest rates on domestic demand has probably increased. A lower peak in the cash rate is required this time around to have the same impact on household cash flows as a 6.5% cash rate had last time.
Yet there are reasons to believe the RBNZ may face a more robust economy than was the case in 2000. In our view, at least part of the economic slowdown during that year reflected business concern about the policy direction of the new Labour/Alliance Government. While many of those concerns still remain, we believe business has learnt to live with the new Government.
Perhaps more important is the turnaround in net migration levels. Net inflows are now running at levels comparable with the peaks in the mid-1990s. That peak added to the upward pressure on house prices then and, we believe, is likely to do so now. This will have a positive impact on household wealth.
The economy also appears to be closer to full capacity now than in 2000. While the QSBO's capacity utilisation measure is at similar levels, the unemployment rate is notably lower. Firms are also reporting it much harder to find skilled labour now than during 2000 (though the skill shortage measure is easing). As always, of course, there are factors pointing the other way. For example the terms of trade are now falling quite sharply. The key conclusion, however, is that it is possible to run the argument that the OCR could peak at similar levels to last time, if not higher.
Market evolving as expected ahead of rate hikes Importantly, given this, the evolution of the market in the lead up to the coming tightening cycle looks broadly consistent with what happened prior to the start of the last tightening cycle.
In the above chart, for instance, we've plotted the difference between the 2nd and 5th NZD bank bill futures. In doing so we are conscious of the lack of liquidity in the far dated NZD bill futures. Still, we don't think this is too much of a problem for our analysis. What this chart suggests is that the NZD bill strip is not excessively steep given the historical experience and the absolute level of the OCR.
Looking elsewhere, if you consider the 1Y out of 1Y forward-start swap it is now trading at a similar margin to cash as in late 1999. The experience in 1999 would suggest the level for the 1Y out of 1Y is some way from its peak. We believe this will be the case and, to this end, in a report published a few weeks back we targeted more than 7.5% as the entry level to wait for before entering such a trade.
While we think it very unlikely that the OCR will rise anywhere close to the levels presently priced, especially if the NZD appreciates, history strongly suggests there is little upside in buying the NZ front end ahead of the first rate hike. This is especially so when we cannot show that the present levels for the market are excessive relative to the historical experience.
Having said this, we do think it could be profitable to disagree with the market's expectation that the first rate hike could happen as soon as April. We believe, for instance, there is value in being long very short dated physical paper at present. We might also consider buying the June bill futures just ahead of the RBNZ meeting, though we would be mindful of US data releases in so doing since we think these will generally surprise on the strong side and thus be negative for the market. Apart from this we would not yet recommend any outright exposure to the NZ front end. Rather, we believe the time to buy will likely be after the RBNZ has begun to move.
David Plank, Fixed Income Strategist
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