Interest rates – the new drivers
The US Federal Reserve and the Reserve Bank of New Zealand both have new bosses but as CMC Markets' Sheldon Slabbert observes, they are likely to be heading in different directions on interest rates.
There‘s a changing of the guard taking place at central banks both here and in the United States.
In the US, Jerome Powell has taken from Janet Yellen and locally, Adrian Orr is set to step in as new Reserve Bank Governor on March 27. And so far, the markets have very different expectations from the two new leaders.
Powell is seen as more hawkish, and many believe he’ll look to tighten financial conditions further and follow through on the rate hiking cycle initiated in December 2016. He’s expected to be less sensitive to the expected gyrations in the stock market and likely to stay the course towards normalisation of monetary policy, which has remained accommodative for longer than most ever expected. The markets are predicting a 30 percent chance of another three hikes this year.
Domestically, Orr is seen as a bit more dovish and, over the next year at least, is expected to keep rates on hold and conduct a supportive monetary policy regime.
The divergence in policy has seen the shrinking away of the once healthy yield premium provided by New Zealand bonds over that of the US. We now see the comparable US 10 year Government Bond Yields trading at a premium over that of New Zealand with a yield of 2.90 percent as compared to 2.83 percent at the time of writing. Some participants are expecting the US 10 Year to push to 3.75 percent by December.
This is not the norm. Some have floated the idea that New Zealand is seen as more of a safe haven now, while other fundamental facts may also be distorting the financial landscape - such as the enormous amount of bond issuance pushed onto the market by The United States. This oversupply has dampened demand, with lower prices pushing up yields in the process.
We have seen the US National debt race up by US$1.2 trillion over the last year alone and the slate of bond issuances for 2018 is set to continue. This has prompted a number of industry experts, like Paul Tudor Jones to predict potentially serious consequences. “The markets disciplined Greece for its budget transgressions and it’s only a matter of time before they discipline us.”
Other observers such as Jim Grant and Ray Dalio are adding to these concerns, stating that the 30-year bond bull market that started in 1981 has come to an end, and that we have entered into a new bear market in bonds.
The Fed’s move this week is symptomatic of the change in tack by the major central banks since early 2017, where there has been a clearer intent to rein in the extreme monetary policies of the past decade. The Fed has been the first mover in the tightening process, just as they were first to ease during the GFC - followed by the Bank of England that has since raised rates and is widely expected to do so again in May. The ECB is expected to end their asset purchasing programme in September with the People’s Bank of China tightening credit conditions further in China.
As the excess liquidity is withdrawn from the markets we could well expect higher volatility in asset prices. We have seen the first salvo fired in February as bond markets sold off with a subsequent squeeze higher in rates. We could also well expect to see increased volatility as asset prices adjust to the new financial conditions following a decade of expansion.
While the outlook is that the RBNZ will stay on hold for the year ahead, it does not mean that borrowing costs will remain unaffected. New Zealand banks borrow offshore - we have already seen borrowing costs rise, and they’re expected to rise further. Thus even if the Reserve Bank remains on hold, banks will pass the cost on to borrowers.
We have already seen some impact in the housing markets (and consumer behaviour that may lead to recessions) in the form of higher mortgage costs in the UK and Canada, as borrowers come off their fixed rate terms and have to reset at a higher rates. There is some reason to expect the same in New Zealand.
When one looks at the historical ranges of interest rates in New Zealand it is not hard to see that the 20 percent plus rates of the 1980s were outliers, just as the sub two percent rates are today.
As the major central banks continue down a path of normalisation, the Reserve Bank may be forced to play catch up and the current policy divergence not expected to last. While a move in rates this year will come as a surprise, 2019 may see the start of a reversion to the mean.
Currency markets have remained fairly range bound, with the New Zealand Dollar firm across most trading partners despite the changing yield differentials. This is unlikely to remain the case as the repricing in the bond markets is expected to spill over into currency markets and also force adjustments across other asset classes. The road to monetary policy normalisation may be a bumpy one.
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