NZ Front End Offers Value Against Australia
Data Flash (New Zealand) NZ Front End Offers Value Against Australia
The market believes the gap between the OCR and the RBA cash rate will continue to widen.
We think this presents a trading opportunity, especially if weak building approvals data due today sees the AUD bill strip make additional gains relative to the NZD strip.
Given liquidity, we also think receiving the 2Y NZD swap and paying the 2Y AUD swap at a spread of more than 120 bp has considerable appeal.
Market prices RBNZ/RBA cash differential of more than 125 bp The rate hikes by the RBNZ over the past 6 weeks has driven a 100 bp wedge between the OCR and the RBA cash rate. What's more, the market thinks the gap will grow. The margin between the respective Sept 02 bill contracts is more than 130 bp.
The present gap between the second futures contracts is close to the widest since the OCR was introduced. Given the different approach to monetary policy taken by the Banks in recent months this is perhaps not surprising. We do not believe that the relative performances of the two economies will sustain such a gap for long, however.
NZ market already factors in a relatively aggressive RBNZ stance The NZ market is pricing a cash rate of close to 6.75% by the end of the year. This looks far too high given the rising NZD, the level of household debt and so forth. Yet one relationship paints an even more bearish picture than presently priced. Namely, the link between short term interest rates and non-tradable inflation. Non-tradable prices are already rising at an annual pace of 2.6%. With some good quality outcomes from 2001 to drop out of the annual figures this year, the pace will almost certainly exceed 3%.
The historical relationship between the two suggests that a rise in non-tradable inflation above 3% could place considerable upward pressure on short term interest rates over and above what is already priced. The alternative is that the RBNZ will tighten much less aggressively than the move in non-tradable inflation might imply given the historical track record.
We think there is reason to believe the RBNZ has changed its approach. To be specific, the RBNZ has moved much earlier this time around. By the time the Bank tightened in 1994, non-tradable inflation had been rising for almost two years. This time the start of the tightening cycle has coincided with the turning point in non-tradable inflation. While this will not prevent non-tradable inflation rising above 3% this year, it will give the Bank considerable comfort that it is not lagging inflation developments as in 1994. Already we have seen modest declines in consumer and business confidence following the rate hikes. This, plus the early start to the process, gives us comfort that the peak in the cash rate will not exceed the previous peak and could well be lower. In which case NZD bills offer value.
Value disappears from AUD bills
At the same time, the gains made by the AUD bills over the past month mean much of the value present at the beginning of April has disappeared. For the most part this reflects the impact of changes in the outlook for the US economy and the Fed. While the market sees no reason for the RBA to wait for the Fed, the lack of urgency to tighten in the US is expected to have a marked impact on the RBA's assessment of the risks and their urgency to move.
The present levels for the AUD bills actually match our own expectations for RBA rate hikes fairly closely. In which case we would not advocate any significant outright positions in the bills at present levels. We are conscious, however, that the RBA seems to be starting the tightening process quite late relative to the strength of the economy. If the tone of the US data and thus sentiment toward the Fed changes at some point in the future, then we think the AUD bill strip would be very exposed. Thus, now that much of the value has gone out of the AUD bills we think there is a case for shorting them against a market where value still exits. As explained above, NZ appears to be such a market.
Are bills, bonds or swap the best way to go long NZ and short Australia? In our view the present gap between the NZD and AUD bills presents a trading opportunity. Given the limited liquidity in the NZD bills, however, it is useful to consider whether a similar (or even better) opportunity exists in the bonds or swaps.
The charts below suggest not in the case of the 3Y NZGB/ACGB spread. Indeed, at less than 100 bp (despite the recent rally in the Australian market we might add) it looks more likely to widen than narrow. The 2Y NZD/AUD swap spread looks more appealing. At its present level of more than 120 bp the 2Y swap spread is as wide as at any point since the OCR was introduced. Given the reasonable level of liquidity in the 2Y NZD swap, we think this spread is an attractive alternative to buying Sep 02 NZD bills against Sep 02 AUD bills. The carry on the trade is close to zero. (Note also that the gap between the 3Y bond spread and the 2Y NZD/AUD swap spread is also unusually large.)
Why not simply go outright long? While sentiment in the US remains supportive of lower rates, the NZ front end will likely rally in sympathy. Though we see scope for further gains in the near term, with the April payrolls data critical in this regard, we think the market is becoming increasingly exposed to a change in sentiment. In which case the spread trade will likely outperform an outright trade.
Fixed Income Strategist