Is the NZ Short End Pricing in too Much Tightening
Bottom Line: The September 2000 bill contract is pricing in a cash rate of 7% - 250 bp more than the current OCR.
While this looks excessive on the basis of current economic fundamentals, currency weakness and the risk premium priced into the bond market suggest it will not be taken out in a hurry. Indeed, if the currency weakens further short-term interest rates will move higher.
Even if the RBNZ keeps the OCR unchanged at its review on 29 September (which we still think is the most likely outcome), the short end will remain vulnerable to currency weakness.
The short end is also exposed to the likelihood that, if the past is anything to go by, the RBNZ will not only tighten by 50bp in November but will also revise up the tightening profile it has built into its projections.
With the RBNZ in tightening mode, going long the short end of the yield curve will only prove profitable in the following circumstances:
1.If the currency rises and takes the MCI above the RBNZ's projected track, thus shifting the burden of the tightening away from interest rates.
2.At the very short end, where the market might price in too high a probability of an RBNZ move in the interim OCR reviews. This situation now exists for the Sep 99 bill contract.
What exactly is the market pricing in?
The chart below shows how much tightening the market is supposedly pricing in, relative to that assumed by the RBNZ. As can be seen, the market is much more pessimistic about the outlook for short-term interest rates than the RBNZ.
Even given a pessimistic view on NZ's inflation performance, a cash rate of 7% by Sep 2000 looks too high. However, what is built into the bill strip does not simply reflect the market's view of the likely level of the cash rate. There is also a relationship between the bill curve and the risk premium priced into the NZ bond market.
As well as expectations about the OCR, the bill strip reflects the present level of NZ 1-3 year swap rates. In turn, swap rates reflect expectations about monetary policy, credit risk and the general risk premium on NZ assets. With the 1 year swap rate at 5.8%, the 2 year at 6.65% and the 1 year out of 1 year forward start swap at close to 7.5%, the bill curve has to price in higher rates almost regardless of the "economic" fundamentals.
Of course, relative to the economic fundamentals and the likely cash rate in 12 months time, swap rates look excessive. However, this will remain the case so long as the market wants to build in a large risk premium. With concerns over liquidity ahead of Y2K, an election, pressure on the currency and the global widening of swap spreads there seems little reason to expect the risk premium on NZ assets to decline in the near-term. Indeed, the pressure is for the exact opposite.
What will happen when the RBNZ tightens?
The RBNZ has clearly signalled that so long as the data pans out as expected it intends to raise the OCR on 17 November - the date of its next Monetary Policy Statement.
Using the projected track for monetary conditions published in the August MPS (and charted above), the RBNZ presently expects the increase to be 50 bp. While a rate rise in November remains conditional on the data, we think it is very likely. The outlook for global growth is likely to keep improving, with this improvement flowing directly into the RBNZ's forecasts via its use of consensus forecasts. We expect the domestic data to be at least as strong as projected by the RBNZ, with some prospect that capacity constraints are greater than expected. Currency weakness, if it persists, will also have an impact on the RBNZ's thinking.
More important for the market than the actual rate increase, however, will be the RBNZ's revised outlook for the path of monetary conditions. This is almost never static from forecast to forecast. History suggests that once the direction of monetary policy is firmly established, the RBNZ will continually revise the projected path for monetary conditions in the same direction. For example, when it was easing in 1997 and 1998 it revised down the MCI track in each Statement. Similarly, during the tightening phase in the mid-1990s the amount of tightening needed to bring inflation under control was revised upwards in each statement. Thus, not only will the OCR be increased on 17 November but, in all likelihood, the projected track for monetary conditions will be revised up at the same time. This will keep the debt market on the defensive even if the actual tightening is in line with expectations.
Trading opportunities at the short end
While a cash rate of 7% by September 2000 looks very unlikely given the current economic fundamentals, which have the economy growing moderately but not explosively, the above discussion suggests there may be little opportunity to profit from taking such a view - certainly not in the present environment.
A significant rally in the far dated bill future contracts will require currency strength and/or a rally in the NZ bond market - either via a reduction in the risk premium or a rally in global bond markets.
At this point neither seems very likely. While the NZD looks cheap relative to the domestic fundamentals and the prospects for the global economy, the same factors impacting on the bond market are also impacting on sentiment in the currency market.
Should the NZD rally it will have its greatest initial impact on the near- term bills by reducing the prospect of the RBNZ moving more than 50 bp by 17 November. The Dec contract is now close to pricing in 2 50 bp rate hikes. While possible, we think this is unlikely. As discussed in previous notes, the RBNZ has published research that concludes that reacting to currency movements before a full review of the inflation outlook has been undertaken often leads to policy errors. While this does not rule out a rate hike at the interim review on 29 September, it would seem to make it unlikely.
The September contract is also close to pricing in a certain rate hike ion 29 September. The risk-reward on going long these contracts is beginning to look very favourable.