RBNZ On Hold: Implications For The Front End
Data Flash (New Zealand)
RBNZ on hold: Implications for the front end
The market has decided that the RBNZ is not likely to tighten again in 2002. We concur and, further, think the RBNZ tightening cycle may be over. In which case the market may begin to consider when rates will start heading down. But with the domestic data still reasonably robust and the NZD having lost some ground, the RBNZ is still likely to retain a tightening bias in the MPS to be published next week. For this reason we would take profit on any long positions in the front two bill contracts at present levels.
Given that we now expect the Fed to ease at some point in the next few months we are still comfortable with long positions further along the curve, as we expect Fed easing to provide support.
Relative to Australia, however, we believe that the NZ market will initially lag in its reaction to the Fed. We would wait for this to take spreads between NZ and Australia to wider levels before advocating buying the NZ front end against Australia.
Market no longer expects the RBNZ to tighten in 2002
The NZ market has completely taken out any prospect of the RBNZ tightening again this year. Given the recent weakness of the US data (ISM, payrolls etc), the related speculation that the Fed may cut rates in the near term and signs of a turning point in the NZ economy this is perhaps not surprising.
In our view, if the RBNZ holds the Official Cash Rate (OCR) at 5.75% it will be difficult for it to resume tightening anytime soon. The indicators suggest the peak in NZ activity is most likely past. To this we need to add the facts that the Policy Targets Agreement will be amended in someway and a new Governor will be appointed. As a consequence Deutsche Bank's forecast peak in the OCR is now 5.75%.
This conclusion naturally leads to speculation about the timing of any downward move in the cash rate. In thinking about this it is worth noting that the NZ data still points to resilience in consumer spending. Though the monthly data suggest the growth rate is past its peak, the volume of retail sales still grew 1.2% in the June quarter. As well, the employment data for the same quarter indicate that GDP growth could be as strong as 1% in the June quarter. While demand growth may slow a lot over coming quarters, the RBNZ will be hesitant to ease since any slowdown will be happening from a very high level of capacity. Our NZ economists believe that these considerations will encourage the RBNZ to forecast further rate increase in the Monetary Policy Statement (MPS) to be published next week (though we don't believe the RBNZ will ultimately follow through on this forecast).
Exit front two bill contracts at present levels
With the market pricing no more rate hikes and the recent data suggesting the RBNZ will still indicate a modest tightening bias in next week's MPS, we would exit long positions in the front two bill contracts at present levels. While it seems likely that the bills will make further gains should the Fed ease as we expect, we think there is more value further along the curve given that the market is likely to see the RBNZ taking its time before it would think of easing.
Short term underperformance versus ACGBs likely if Fed does ease Indeed, we think the market may initially see the RBA as more likely to follow the Fed than the RBNZ. This is despite the fact the Australian domestic economy is running very strongly. We note that during last year's post September 11 easing cycle the market consistently priced the RBA more aggressively than the RBNZ. even though the RBNZ actually eased by more than the RBA after the attack. We think this reflects the market's belief that the RBNZ is inherently more "hawkish" than the RBA. The RBNZ's aggressive tightening over the past few months may be seen as "proving" this belief.
The chart below attempts to capture this by plotting the difference between the interest rate implied by the first 3M bill futures contract and the actually cash rate in each country.
As can be seen, the initial response was for the NZ market to price only a modest rate cut while the Australian market priced a more aggressive RBA response. This was despite the fact that the OCR was already well above the RBA's cash rate when the attack happened. We would not be surprised to see a similar development over the next few weeks if the Fed does ease, even though rates are much more stimulatory in Australia than NZ.
In which case, market interest rate differentials between NZ and Australia seem likely to widen in the near term. Since the 3Y NZGB/ACGB spread of less than 80 bp is already narrower than the present cash differential of 100 bp we think this part of the NZGB curve is particularly exposed to short term underperformance relative to ACGBs if the Fed does ease.
Of course, this underperformance will only be sustained if in fact the RBA does deliver a greater reduction in the cash rate than the RBNZ. But, as we saw post September 11, the RBNZ may actually surprise the market in its policy reaction. Alternatively, the RBA could disappoint and not follow any Fed easing as aggressively as the market expects (if at all).
This is effectively what happened after September 11. While the market initially priced a much more aggressive easing by the RBA and the 3Y NZGB/ACGB spread spiked higher as a result, this proved short lived. The RBNZ surprised the market on 19 September by easing 50 bp. This action immediately set the 3Y NZGB/ACGB spread on a narrowing path.
We think this price action could be instructive of the likely market behaviour post any Fed easing. Namely, that the market will initially be more aggressive in extrapolating a likely RBA response than it will an RBNZ response. In our view this could take NZGB/ACGB spreads to levels where it would be attractive to buy the front end of the NZ market against Australia. For now, however, we think it is difficult to advocate such trades especially given that the 3Y NZGB/ACGB spread is already trading below the current cash spread.
David Plank, Fixed Income Strategist
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