Download A shift in bond market drivers

HARBOUR INVESTMENT COMPASS
FIXED INTEREST MONTHLY COMMENTARY – October 2016
FIXED INTEREST OVERVIEW FOR THE MONTH
•
Global yields rose in October, as the markets became less fearful of deflation, and less certain
of ongoing monetary policy stimulus. The 10 year US government bond yield rose 20 basis
points to 1.80%.
•
As a result, beneficiaries of the global search for yield underperformed in October. The NZ 10
year government bond yield rose around 45 basis points to 2.70%. The high yielding New
Zealand sharemarket also underperformed against global markets.
•
Locally, the market continues to place around an 80% chance of the RBNZ delivering on its
easing bias with a 25 basis point cut in November. However, local economic news since the
August MPS has reduced the case for further cuts from the RBNZ. The NZ 2 year swap rate
rose around 15 basis points to 2.15%.
•
Activity in New Zealand credit markets has continued to pick-up, with an increase in corporate
bond issuance.
A shift in global bond market drivers
Over the course of October, global bond markets experienced a sort of volatility and change in
sentiment not seen since the so-called “Taper Tantrum” of mid-2013. Fears of deflation have been
replaced by an acknowledgement that inflation is low but rising. Equally, expectations of continual
monetary policy stimulus have been replaced by a sense that the age of easy money is eventually
coming towards its end-game.
A number of factors combined in October, each small in isolation, but supporting this change in
theme for markets:
-
China posted its first positive annual PPI inflation number since 2012, highlighting that an
age of cheap labour and deflation in manufacturing goods from Asia may be coming to an
end.
-
There were a number of speeches by prominent central bankers and politicians continuing to
highlight the limitations of loose monetary policy. Both ECB President, Mario Draghi, and UK
Prime Minister, Theresa May, emphasised these themes.
-
The UK economy posted much stronger GDP numbers than expected, debunking market’s
fears that Brexit would result in an inevitable recession. The market has now begun to price
in the chance of the Bank of England hiking the Bank Rate, only months after a post-Brexit
round of quantitative easing was announced.
1
-
Finally, the United States continued to print solid economic data, highlighting the reduction
on post-GFC spare capacity. Indeed, with the US Federal Reserve continuing to emphasise a
very cautious approach to lifting the Fed Funds Rate, the market has started to price in the
chance that US inflation begins rising, as the combination of loose monetary policy and tight
labour markets result in increased wage pressures.
One noticeable signal of this change in sentiment was the rise in so-called Breakeven Inflation (BEI)
rates, from the inflation-indexed-linked market. Inflation breakevens have been falling for the past
couple of years, particularly since the fall in oil prices in late 2014. However, in October these
inflation breakeven rates have finally risen sharply, as fears of deflation have abated, replaced by
growing confidence that inflation is heading back toward central bank targets of 2%.
Chart 1. Implied 10 year Breakeven Inflation (BEI) rates
Percent
3.00
2.50
2.00
United States
1.50
Australia
New Zealand
1.00
0.50
Jan13
Jul13
Jan14
Jul14
Jan15
Jul15
Jan16
Jul16
Source: Bloomberg and Harbour Asset Management.
The New Zealand government bond market was not immune to this change in factors driving global
markets. As a beneficiary of the global search for yield in recent years, the New Zealand government
bond market underperformed in October, with 10 year government bond yields rising around 45 basis
points to 2.70%. In the same spirit, the high yielding New Zealand sharemarket also underperformed
against global markets.
In our view, the rise in global yields in October represents a correction in markets, where bond
valuations had become stretched, and markets seemed to have pessimistically ruled out any change
of central banks ever getting inflation back to 2%.
While the rise in global yields in October is justified on these grounds, we also believe that there are
still anchors in place that will limit how far yields can rise. In particular, high levels of debt-to-income
post-GFC mean that economies are still not able to operate with high interest rates. Recognising this,
the US Federal Reserve has continually revised down its assumption for the long-term Fed Funds
Rate. Furthermore, with cash rates still anchored at low levels, at some point higher bond yields
start to look like an attractive investment, enticing demand for bonds.
2
While existing market positioning and increased volatility are making investors cautious at the
moment, at some point we suspect the market will find support. In our opinion, the US 10 year
government bond yield may continue rising toward 2.00%, but it would be harder for yields to lift
above 2.25% without a significant inflation surprise.
The case for RBNZ cuts is weakening
The short end of the yield curve in New Zealand also rose during the course of October, with the 2
year swap rate lifting around 15 basis points to 2.15%.
At first this looked to be a move unrelated to domestic developments, and more in sympathy with
the rise in global long-term yields.
The RBNZ has held a remarkably strong easing bias since the August Monetary Policy Statement
(MPS), helping keep the chances of 25 basis point cut in November priced at around 80% by markets.
This has been supported by consistent messaging from the RBNZ in the August MPS, September OCR
Review, and the chief economist’s speech on inflation in October. In each of these, the RBNZ has
downplayed the pick-up in indicators of economic activity, emphasised the importance of lifting
inflation back to target, and re-iterated that according to their assumptions “more easing will be
required”.
However, since the August MPS there has been a noticeable change in economic data, and this will
necessitate a change their projections, and so the chances of further cuts. In particular:
-
Dairy prices are around 30% higher than the August MPS projection, when the RBNZ had
assumed they would stay at low levels.
-
Net migration has reached new record levels of 6,500 per month, when it was projected to
abate closer to 3,500 per month.
-
Economic activity has been strong, with the unemployment rate falling to 4.9%, the lowest
level since 2008, further illustrating the lack of spare capacity.
The RBNZ published two ‘downside scenarios’ in the August MPS: one where the exchange rate
remained stubbornly high; the other where inflation expectations continued to fall making the
RBNZ’s job of getting back to target even harder. Neither of these risk scenarios in our view have
really played out.
-
The NZ Trade-Weighted Index (TWI) is only around 1% higher than the RBNZ’s projection
back at the August MPS, which is hard to call “unjustified” when dairy prices have risen 30%
over the same period.
-
Inflation expectations have not fallen since the August MPS. Indeed, NZ breakeven inflation
rates from the inflation-indexed-linked market have risen from around 0.50% to over 1.10%
over that period. The NZ Consumers Price Index (CPI) inflation outturn for Q3 was the first to
come in ahead of economists’ forecasts for some. Perhaps most importantly, there was a
material lift in the RBNZ’s own inflation expectations survey. Although the ‘mean’ for the 2year ahead expectations only moved from 1.65% to 1.68%, the ‘median’ has moved from
1.70% to 1.90%, and chart below shows that the ‘mode’ of the sample is above 2%. This
3
hardly paints a picture of deflationary fears or even concerns that NZ CPI inflation will remain
outside the 1-3% range.
Chart 2. Distribution of 2-year inflation expectations
Source: Reserve Bank of New Zealand.
Working through the changes in economic data since the August MPS, one of the few factors
strengthening the case for a cut is the fact that only around 10 basis points of the 25 basis point cut in
August was passed onto floating mortgage rates. However, this tightening in credit conditions was
in part brought about by the RBNZ’s own macro-prudential policies, designed to reduce the provision
of credit to high loan-to-value borrowers. So it is difficult to argue this reduced pass-through to
mortgage rates was a surprise requiring further cuts from the RBNZ. That said, we do note that bank
lending conditions to the broader corporate market have also tightened.
In our view, that leaves the strongest remaining reason to cut the fact that the RBNZ has previously
communicated such a strong, consistent, easing bias – and that they will feel obligated to deliver on
it. Indeed, this is the plank that most market economists are basing their judgment that the RBNZ
will cut in November, not their view of the economic fundamentals.
In this sense, we observe some strong parallels with the RBNZ’s communication approach during the
hiking cycle from 2.50% to 3.50% in 2014. On that occasion, the case for hikes was strong in March
2014. But the economic justification had already begun to unravel by the time they felt obliged to
deliver on their signal to hike to 3.50% in July 2014.1
With a November rate cut 80% priced by markets, our central view is that the RBNZ delivers on its
easing bias and reduces the OCR to 1.75%. However, in our opinion this is far from certain, and
closer to a 50:50 call. Certainly, beyond November the RBNZ will have far less grounds to retain a
1
“July RBNZ hike not a done deal”, Harbour Navigator, 21 July 2014.
https://www.harbourasset.co.nz/wp-content/uploads/2014/07/Harbour-Asset-Managements-Navigator-July-RBNZ-hikenot-a-done-deal.pdf
4
strong easing bias, even if there is a temptation to do this as a tactical ploy to keep the NZ dollar
lower.
As we roll into 2017, it is our view that headline CPI inflation will be rising above 1% for the first time
since 2014, as the previous drop in oil prices falls out of the annual number. This in itself should
prompt inflation expectations to continue shifting higher, even if getting to 2% may remain a
challenge.
Christian Hawkesby
Executive Director
October 2016 |
[email protected]
This column does not constitute advice to any person.
www.harbourasset.co.nz/disclaimer/
IMPORTANT NOTICE AND DISCLAIMER
The New Zealand Fixed Income Commentary is given in good faith and has been prepared from published information and other sources
believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information
and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without
notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that
any such contents constitute advice, they do not take into account any person’s particular financial situation or goals, and accordingly, do
not constitute personalised financial advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting
or other nature to any person.. The bond market is volatile. The price, value and income derived from investments may fluctuate in that
values can go down as well as up and investors may get back less than originally invested. Past performance is not indicative of future
results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest
rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. Where an
investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of
the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can
change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the
impact of investment decisions on your tax position. To the maximum extent permitted by law, no liability or responsibility is accepted for
any loss or damage, direct or consequential, arising from or in connection with this document or its contents. Actual performance of
investments managed by Harbour Asset Management Limited will be affected by management charges. No person guarantees the
performance of funds managed by Harbour Asset Management Limited.
5