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18 February 2005
Paper 1.2
Key developments in
financial markets
Macro-financial
Advice:
SUMMARY
David Drage
x 3819

Global long-term interest rates have fallen and yield curves have flattened
since December. Although there are many contributing factors, this
would tend to suggest markets are increasingly confident that inflation will
remain well contained and economic growth will be solid, but
unspectacular, going forward.

The US dollar has rebounded since December, as markets have focused
more on the relatively strong cyclical position of the US economy and less
on the US current account deficit. Despite the resurgence in the US
dollar, the New Zealand TWI has continued to appreciate, in line with
upside surprises to recent domestic data.

Markets have revised up their OCR expectations after a string of upside
surprises to domestic data. Markets are pricing a slightly better than even
chance of another rate rise by the middle of this year.

Although mortgage rates have risen since December, market contacts
suggest there is a risk of another price war this year.
Clinton Watkins
x 3967
Nick Smyth
X 3787
Daniel Wills
x 3815
Christina Leung
x 3642
GLOBAL BACKDROP
Global yield
curves have
flattened since
December
Global yield curves have flattened since December as markets have revised up
monetary policy expectations in most economies (particularly Australia) and as
long-term interest rates have generally fallen (see graph below).
Global yield curves have continued to flatten since the Decmber MPS
basis
points
change in 2 year government bond rates
change in 10 year government bond rates
60
50
40
30
20
10
0
-10
-20
Australia
Ref #161574
US
UK
NZ
ECB
Japan
Canada
2
Markets expect
the Fed to
continue to be
“measured”
Fed Funds
rate (%)
The US yield curve has led the way, flattening considerably since the December
MPS, as short-term interest rates have risen and long-term interest rates have
fallen. Markets are confident that the Fed will continue to raise the Fed funds rate
at a “measured” pace because of some slightly stronger than expected US
economic data and some hawkish comments from Fed officials. Fed officials
have signalled that the Fed funds rate is still accommodative. The market’s
central view is that the Fed will gradually return the Fed funds rate to more
‘neutral’ levels around 3.50%, at which point the Fed can wait and see how the
economy is functioning (see graph below).
Markets expect the Fed will raise rates at the next 2 meetings before
possibly pausing around the middle of the year
(As derived from OIS rates without a term premium)
3.75
3.50
3.25
3.00
2.75
2.50
The majority of traders
and analysts see the Fed
funds rate at around 3.5%
by the end of 2005
2.25
2.00
Just after the December MPS
1.75
1.50
Today, 18 February
1.25
1.00
0.75
Jan 04 Mar 04 May 04
The fall in US
long-term
interest rates a
‘conundrum’
Jul 04
Sep 04 Nov 04 Jan 05 Mar 05 May 05
Jul 05
Sep 05 Nov 05
At first glance, the relatively low level of long-term US interest rates might seem
unusual. Current levels of economic growth and inflation would tend to suggest
higher long-term interest rates (see graph below). Economic theory suggests that
long-term (risk-free) interest rates should equal the return on capital in an
economy (which is, roughly speaking, growth in real GDP), and an inflation
premium. Fed Chairman Alan Greenspan recently said that the current levels of
long-term rates were a “conundrum”.
US 10-year interest rates seem too low compared to current US
growth and inflation rates - Greenspan's 'Conundrum '
%
20
Real GDP
Inflation (GDP deflator)
US 10 year interest rate
15
10
5
0
-5
1980
Ref #161574
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
3
‘Nonfundamental’
factors have
pushed US longterm rates lower
Market participants, as well as the Fed Chairman, agree that ‘non-fundamental’
factors have contributed to the low level of US long-term rates, although there is
no consensus about how important these factors have been. These factors
include investment in long-term bonds associated with the ‘carry trade’ (discussed
further below), pension funds buying long-term bonds to increase the durations of
their portfolios, and Asian central banks buying US government bonds as part of
their foreign exchange intervention programmes.
…But low US
long rates might
reflect lower
growth
expectations
But long-term interest rates also tend to reflect market expectations of growth and
inflation going forward. Although there are numerous explanations for why US
long-term interest rates are relatively low, this would tend to suggest that markets
expect inflation will remain well contained and economic growth will be solid, but
unspectacular, going forward. The market’s view of US economic growth, as
suggested by long-term real interest rates, appears considerably lower than
consensus forecasts (see graph below).
Consensus forecasts seem far more optimistic about
US growth prospects than do markets
%
5.0
4.0
3.0
US real yields (TIPS)
2.0
US GDP growth (3yr avg) with consensus for 05
and 06...
with lowest forecasts for 05 and 06
1.0
with highest forecasts for 05 and 06
0.0
1997
1998
Equity markets
have continued
to rise, buoyed
by strong
corporate
earnings
1999
2000
2001
2002
2003
2004
2005
2006
2007
In contrast to the falling US long-term interest rates, US equity markets have risen
since the December MPS, boosted by solid corporate earnings and some
stronger than expected macroeconomic data. Two-thirds of corporates have
reported earnings that beat expectations, and earnings growth was broad-based
across industries (all industries reported positive earnings growth).
US corporate earnings were again very strong in the December quarter,
although markets expect earnings to moderate going forward
% growth
(S&P500 earnings announcement data)
30
20
10
0
Estimate with 73%
firms having reported
-10
Estimated earnings growth (start of the quarter)
-20
Actual earnings growth
Ref #161574
3Q
05
2Q
05
1Q
05
4Q
04
3Q
04
2Q
04
1Q
04
4Q
03
3Q
03
2Q
03
1Q
03
4Q
02
3Q
02
2Q
02
1Q
02
4Q
01
3Q
01
2Q
01
1Q
01
4Q
00
3Q
00
2Q
00
1Q
00
-30
4
But markets
expect earnings
growth to
moderate going
forward
But broad equity market trends also tend to support a story of contained inflation
expectations and solid, but unspectacular, growth prospects. First, annual growth
in equity prices has moderated over the past few quarters (see graph below).
Second, current and future earnings growth has been revised down in the
consumer sector. The consumer sector is pro-cyclical and is therefore considered
a barometer of economic conditions. Third, markets expect growth in corporate
earnings to slow from current levels over the year ahead (see graph above).
Growth in equity prices is moderating, maybe
reflecting lower GDP expectations going forward
% change yoy
10
Real GDP year on year % change
% change yoy
60
S&P500 year on year % change advanced 2 quarters
8
40
6
20
4
2
0
0
-20
-2
-4
1980
-40
1982
1984
Corporate bond
spreads have
narrowed…
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Consistent with recent strong corporate earnings, corporate bond spreads have
continued to narrow since December (see graph below). The corporate bond
spread reflects the greater risk that corporate bonds carry relative to government
bonds. Although corporate earnings suggest that US balance sheets are in
relatively strong shape, the very narrow level of spreads has started to worry
some policymakers. Fed Chairman Alan Greenspan and ECB president JeanClaude Trichet have recently said that some investors might be taking excessive
risks.
US corporate bond spreads have reached near record low levels, implying that
markets are confident about the economy's future prospects
%
US real GDP (LHS)
Merril Lynch high yield corporate bond spread (RHS, inverted)
6
basis
points
0
5
200
4
400
3
2
600
1
800
0
1000
-1
-2
1987
Ref #161574
consensus
forecasts
1200
1989
1991
1993
1995
1997
1999
2001
2003
2005
5
…driven in part
by low shortterm rates – the
‘carry trade’
A key driver behind the strong demand for corporate bonds and other risky assets
has been the low level of global short-term interest rates over the past few years.
Many investors have borrowed money at low short-term interest rates and
invested the money in assets that pay a higher return, including corporate bonds
and long-term government bonds. Some analysts believe that this investment in
long-term US government bonds has played a significant role in keeping longterm US rates so low. The popularity of the ‘carry trade’ suggests that investors
are implicitly counting on continued solid economic growth and a restrained Fed
tightening cycle.
Markets revise
up monetary
policy
expectations
slightly
Markets have revised up monetary policy expectations slightly in most economies
as central banks have remained upbeat on economic outlooks. Markets expect
most major central banks will tighten rates around the middle of this year, with the
exceptions of the US Federal Reserve (as discussed earlier) and the Reserve
Bank of Australia.
Central bank actions and expected policy moves
Central Bank
[Next rate
decision]
US
Reserve
Federal
Expected timing of next move
Market Prices
Analysts
+25 in Mar 2005
+25 in Mar 2005
Net change in policy
rate since January
2004
[Last move]
+150
Level
of
policy rate
2.50 %
[+25 on 3 Feb 2005]
[14 December]
Reserve Bank of
New Zealand
+25 in June 2005
on hold in 2005
+150
6.50 %
[+25 on 28 Oct 2004]
[10 March]
Reserve Bank of
Australia
+25 in March 2005
+25 in
2005
March
0
5.25 %
[+25 on 3 Dec 2003]
[2 March]
Bank of England
[10 February]
European
Bank
Central
On hold until mid
2005
+25 in mid/late
2005
+100
+25 in mid 2005
+25 in
2005
0
Sept
[+25 on
2004]
4.75 %
5
August
2.00 %
[-25 on 6 Jun 2003]
[3 March]
Bank of Canada
[1 March]
Markets revise
up Australian
interest rate
expectations
Ref #161574
+25 in mid 2005
+25 in mid/late
2005
-25
2.50 %
[+25 on 18 Oct 2004]
The exception to the global trend recently has been Australia. A recent string of
stronger than expected Australian economic data and some hawkish comments
from the Reserve Bank of Australia (RBA) have caused markets to substantially
revise up Australian interest rate expectations. With the RBA recently making it
clear that rate rises are back on the near-term agenda, markets have priced in
two tightenings over the next three meetings. Despite a rise in long-term interest
rates, the Australian yield curve remains inverted, suggesting that markets expect
the Australian economy to slow going forward.
6
RBA cash rate expectations have increased considerably since December
after strong economic data and hawkish comments from the RBA
Basis
points
(RBA cash rate expectations based on OIS rates, without a term premium)
%
100
6.00
5.75
5.50
Change since 10 December (RHS)
90
December 10
80
Today, February 18
70
60
50
5.25
40
5.00
30
20
4.75
10
0
Markets less
concerned with
oil prices
Nov-05
Sep-05
Jul-05
May-05
Mar-05
Dec-04
Oct-04
Aug-04
Jun-04
Apr-04
Feb-04
Nov-03
Sep-03
Jul-03
4.50
Oil prices have played a less important role in interest rate and growth
expectations since the December MPS. Oil prices have risen since December,
mainly because of OPEC threatening to cut production, and cold weather in the
US north-east, a large consumer of heating oil. However, oil prices remain well
below the highs reached in the middle of 2004 (see graph below).
Oil prices have risen since the December MPS, although current
prices are well below the highs in mid-2004
$/barrel
(West texas intermediate, first crude oil contract)
60
average since December MPS = $45 per barrel
55
50
average in 2004 = $41 per barrel
45
40
35
30
25
20
15
Jan-02
May-02
Markets are
beginning to
anticipate
higher oil prices
for longer
Ref #161574
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
Markets appear more comfortable that oil prices will remain around current levels
going forward, as suggested by a narrowing in the spread between near-dated
and long-dated oil futures contracts (see graph below). The spread between
near-dated and long-dated oil futures contracts is suggestive of how much
markets expect oil prices to change going forward. Undoubtedly, recent
comments from OPEC officials have contributed to this sentiment. The OPEC
president said that the world economy can sustain oil prices at current levels and
implied that OPEC would cut production to maintain current oil prices.
7
One-year ahead oil prices are now relatively close to current oil prices,
suggesting markets are getting used to the idea of oil near $50 per barrel
(20 day moving average of the spread between the 12th and 1st crude oil futures contracts)
$/barrel -6
expect oil
prices to
rise in the
future
-4
-2
0
2
4
6
expect oil
prices to
fall in the
future
8
10
12
1989
1991
1993
1995
1997
1999
2001
2003
2005
CURRENCY MARKETS
US dollar has
appreciated
since
December…
The US dollar has rebounded since the December MPS, and particularly since the
New Year, as cyclical factors such as interest rate differentials have played a
more important role in currency markets. Short-term US interest rates are now
higher than those in Canada and the Eurozone. Throughout the latter part of
2004, structural factors, in particular the US twin current account and fiscal
deficits, dominated the minds of currency traders, and caused the US dollar to
depreciate. The resurgence of the US dollar has now caused some uncertainty
over where the US dollar will go from here – will the market’s focus return to the
twin deficits, or will expectations of further Fed tightenings continue to support the
US dollar? The two contrasting views in currency markets are outlined briefly in
the table below.
Expect the US dollar to depreciate going forward
 The recent US dollar rebound is mainly the
result of investors closing out bets that the
US dollar will depreciate rather than investors
putting on bets that the US dollar will
appreciate. Therefore, the recent US dollar
appreciation should not be taken as an
indication of confidence in the currency.
 The US dollar needs to depreciate further to
entice foreigners to lend money to the US to
fund the US current account deficit.
Ref #161574
Expect the US dollar to appreciate going forward
 Currency traders are now focusing more on
the relative cyclical positions of countries. US
economic prospects look far rosier than many
of its trading partners.
 US short-term interest rates are now higher in
the US than in Europe, and Canada.
Therefore, traders will find it more expensive
to bet on the US dollar depreciating against
these currencies.
8
This uncertainty in currency markets is reflected in the small net position that
speculative investors are holding on the US dollar (see graph below). Speculative
investors tend to build up large positions when they are confident about the future
direction of the currency.
…Causing
uncertainty in
currency
markets
Speculative investors are holding almost a zero net position on the US dollar,
implying they are uncertain whether it will appreciate of depreciate
net
position
(The speculative position is calculated as a weighted average of the net positions of the Euro,
Yen, Pound, CAD and Swiss Franc where the weights are determined by dollar index, DXY)
20000
DXY
125
investors expect USD
appreciation
120
10000
115
0
110
-10000
105
-20000
100
-30000
95
-40000
investors expect USD
depreciation
90
-50000
85
speculative positioning on US dollar (LHS)
DXY, dollar index (RHS)
-60000
80
2001
2002
Asian
currencies up,
European
currencies down
2003
2004
2005
In contrast to much of 2004, Asian currencies have performed much better than
European currencies over the last three months (see graph below). Why the
turnaround? First, Asian countries have been under increased political pressure
from European and American officials to bear more of the US dollar adjustment
process to the US current account deficit. China has been the main focus of the
political attention because many officials believe its fixed exchange rate is
undervalued against the US dollar. Second, speculation that China might revalue
its currency higher has contributed slightly to Asian currency strength. Despite
the speculation, Chinese officials have remained adamant that they will move in
their own time – markets expect this to occur sometime next year.
Asian currencies have been among those to appreciate most against
the US dollar since the December MPS , along with the Australian and
New Zealand dollars
6.2
Brazil Real
Australian Dollar
South Korean Won
Mexican Peso
Taiwan Dollar
New Zealand Dollar
Japanese Yen
Singapore Dollar
Canadian Dollar
British Pound
Euro
Danish Krone
Swedish Krone
South African Rand
Swiss Franc
Norwegian Krone
5.2
4.0
3.0
2.8
2.2
1.0
1.0
-0.2
-1.5
-1.8
-1.9
-2.5
-2.6
-3.0
-4.1
-6
Ref #161574
-4
-2
0
2
4
6
(percentage change in currency against the US dollar since December MPS )
8
9
But NZ and
Australian
dollars continue
to rise
Despite Asian currencies bearing more of the US dollar adjustment process
recently, the New Zealand and Australian dollars have continued to appreciate
strongly (see right-hand graph below). Given the extent of the New Zealand and
Australian dollar appreciations over the past three years (see left-hand graph
below), we might have expected these currencies – like the European currencies
– to have borne relatively less of the US dollar adjustment process recently. The
continued appreciations of the New Zealand and Australian dollars are indicative
of the strong cyclical positions of their respective economies and upward revisions
to interest rate expectations.
% change in currency blocs since the US TWI
peaked at the start of 2002
European and Australasian currencies have
%
change borne the brunt of the US dollar weakness since
early 2002 (when the US TWI peaked)
70
% change in currency blocs since the
December MPS
Although Asian currencies have been bearing more
of the US dollar weakness recently, Australasian
%
change currencies have still appreciated strongly
5
4
3
2
1
0
-1
-2
-3
60
50
40
30
20
10
0
Asia
Canada and UK
Uridashi
issuance very
strong
Europe
NZ and
Australia
Asia
Canada and UK
Europe
NZ and
Australia
Consistent with strong foreign demand for New Zealand and Australian
investments, Uridashi and Eurokiwi bond issuance has continued at a rapid pace
since December. In New Zealand’s case, issuance has already hit record levels
this month. Issuance not only creates demand for New Zealand dollars, but the
capital inflows contribute to funding New Zealand’s current account deficit.
However, recent issuance has built up a large volume of maturities from 2006 to
2008, which represents a downside risk to the New Zealand dollar, particularly if
narrower interest rate differentials lead to less issuance over that period.
Uridashi and Eurokiwi bond issuance hit record highs in 2004
and has continued to be very strong in early 2005
Issues
Maturities
27,500
Outstanding (RHS)
3,000
25,000
2,500
22,500
2,000
20,000
1,500
17,500
1,000
15,000
500
12,500
0
10,000
-500
7,500
-1,000
5,000
-1,500
2,500
-2,000
1994
0
Australian dollar
offsetting some
of the rise in the
NZ TWI
Ref #161574
1996
1998
2000
2002
2004
2006
2008
Total outstanding (NZ$million)
Bonds maturing/issued (NZ$million)
3,500
2010
The New Zealand TWI has continued to strengthen since December, and is now
nearing historically high levels. The only currency that has offset the rise in the
TWI since December has been the Australian dollar, which has appreciated
significantly, in line with markets revising up Australian interest rate expectations.
10
The New Zealand dollar had fallen recently against the Australian dollar, as
markets revise up Australian interest rate expectations
(the interest rate referred to is an equally weighted average of the first three bank bill futures rates)
Spread between NZ and AU interest rates (LHS)
spread/bp
NZD/AUD
NZD/AUD (RHS)
160
0.96
140
Interest rate expectations have driven
recent moves in the NZD/AUD
120
0.94
0.92
100
80
0.9
60
0.88
40
0.86
20
0.84
0
-20
Jan-03
0.82
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
As shown in the chart below, the New Zealand TWI is generally expected to
depreciate during 2005. While a weak US dollar environment and New Zealand's
relatively high interest rates are generally expected to provide some ongoing
support, analysts point to the prospect of slowing growth and a widening current
account deficit as reasons for the NZ dollar to weaken. The December MPS TWI
projections remain broadly in line with analyst views, but are towards the upper
end of the range - the December MPS H2 2005 average of 67¾ contrasts with a
median analyst forecast of 64.0 for December 2005.
The December MPS TWI projections for 2005 are towards the upper
end of current market views
Analysts expect
the TWI to fall in
2005
TWI
70
December MPS projection
67
Median
analyst
forecast
64
61
Range of
analyst
forecasts
58
55
Mar-03
Jun-03
Sep-03
Dec-03
Mar-04
Jun-04
Sep-04
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
NEW ZEALAND MARKETS
Markets revise
up OCR
expectations
Ref #161574
Markets have significantly revised up OCR expectations since the December
MPS (see graph below) after a string of upside surprises to domestic economic
data (including employment, inflation, and house price data). Markets are now
pricing in a 40% chance of a rate rise at the March meeting and 55% chance of a
11
rate rise by the middle of this year. Market expectations differ from the broad
analyst consensus that the OCR will remain on hold throughout 2005 (although a
minority of analysts expect another rate rise).
Markets are now pricing in a rate rise over the first half of this year after a
string of upside surprises to domestic data
%
(OCR expectations based on OIS rates, without a term premium)
Basis points
50
6.75
Change since December MPS (RHS)
6.50
45
Just after the January OCR Review
6.25
40
Today, 18 February
35
Just after the December MPS
6.00
30
5.75
25
20
5.50
15
5.25
10
5.00
5
0
NZ yield curve
inverts further
Dec-05
Oct-05
Sep-05
Jul-05
Jun-05
Apr-05
Mar-05
Jan-05
Dec-04
Oct-04
Sep-04
Jul-04
Jun-04
Apr-04
Mar-04
Jan-04
Dec-03
Oct-03
Sep-03
Jul-03
Jun-03
Apr-03
Mar-03
4.75
Although OCR expectations have risen, the New Zealand yield curve has
continued to invert. That is, short-term rates have risen further whereas long-term
rates have been held down by low global rates (as discussed earlier). The
inverted yield curve is consistent with expectations that the New Zealand
economy will slow going forward as the full effects of the rate rises in 2004 flow
through to economic activity.
The NZ yield curve has inverted further since the December MPS, suggesting that
markets believe the NZ economy will slow going forward
Basis points
%
(spread between 10-year and 1-year government bond yields)
300
4
250
positive slope
200
5
150
100
6
50
0
-50
-100
1999
Mortgage war
ends, but for
how long?
Ref #161574
7
10-year 1-year interest rate spread (LHS)
2000
2001
2002
OCR (RHS)
2003
inverted slope
2004
8
2005
Fixed mortgage rates have increased since December as New Zealand swap
rates have increased and as banks have called an end to the mortgage war.
Banks tend to hedge the funding costs of their fixed rate mortgages through the
swap market, so the rise in swap rates (particularly the two year rate) has
increased the cost of providing mortgages. Despite the rise in funding costs,
12
market contacts suggest that the mortgage war could resume sometime this year
and drive down retail mortgage rates.
Two year fixed mortgage rates have rebounded from their preChristmas lows, as the mortgage price war came to an end
%
9.0
2yr fixed mortgage rate
2yr swap rate
2yr govt bond yield
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
2000
2001
2002
2003
2004
2005
For the time being, the effective mortgage rate continues to rise gradually - in line
with the projections made in the December MPS (as shown in the chart below).
However, should longer term wholesale interest rates remain relatively low and/or
the mortgage war resume, there is a risk that the effective mortgage rate will
evolve more in line with the low scenario.
In line with the December MPS projections, the effective
mortgage rate has gradually risen
%
9.0
Effective Mortgage Rate
OCR
8.5
High scenario
Low scenario
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
Dec
98
Ref #161574
Jun
99
Dec
99
Jun
00
Dec
00
Jun
01
Dec
01
Jun
02
Dec
02
Jun
03
Dec
03
Jun
04
Dec
04
Jun
05
Dec
05
Jun
06
Dec
06