By Christian Hawkesby*
Global bond yields stabilised in July, as markets weighed up two opposing forces:
- continued economic recovery pushing yields higher, versus
- yield curves that are steep and already factor-in higher future cash rates.
In New Zealand, the RBNZ finally acknowledged the strength of the NZ economy, opening the door to them removing monetary stimulus faster than previously flagged. The market expects around 50 basis points of hikes by April 2014.
Fonterra’s product safety issues create a new risk to the NZ economy. For fixed interest markets, it will depend on whether the threat to NZ’s export income is material enough to effect overall growth, which in turn will be influenced by the degree to which the currency works as a shock absorber.
Looking further ahead, we continue to see sufficient global and domestic economic momentum to support higher bond yields over the medium-term.
Two Strong Opposing Forces
Global bond yields rose sharply over May and June, following signals from the US Federal Reserve that it was considering ‘tapering’ the size of its Quantitative Easing (QE) bond purchases, as evidence grew that the US economic recovery was gaining traction. The US 10 year yield rose from a low of 1.60% in early May to as high as 2.75% in early July, leaving yields at their highest levels since mid 2011.
Through the course of July, global bond yields began to stabilize, as two strong opposing forces worked against each other.
- Momentum: Bond investors are far more wary about investing in long-term bonds, given the upward momentum of the yields and the fact that the US Fed has signaled that it won’t necessarily cap bond yields with the weight of its QE purchases.
- Valuation: Long-term bond yields have already risen considerably. So those bond investors willing to hold long-term securities are receiving some compensation from considerably higher yields than available from short-term securities and cash (Chart 1).
Some bond maths
Whether it is appealing to invest in long-term fixed interest securities or sit on cash depends on your view on the return from holding cash through time: the longer that cash rates remain near zero, the more attractive it is to hold higher yielding long-dated securities; the faster that monetary stimulus is removed, the more reason to avoid locking in long-term.
The most recent economic forecasts of the US Federal Reserve provide an insight into the expectations of the 19 members of the FOMC (Federal Open Markets Committee). It highlights that while they intend to eventually lift the overnight US Fed Funds Rate back to around 4%, they expect that cash rates can remain near 0.25% for the next couple of years (Chart 2). That is, whether or not they ‘taper’ their QE bond purchases faster or slower, they still intend to keep cash rates anchored.
Using the ‘bond maths’ of fixed interest markets, we can take alternative tracks for US cash rates and back-out what that implies for “fair value” US bond yields for different maturities. In other words, we can take a forecast time series for future US cash rates, and use this to back out what it means for the US yield curve today.
Chart 3 sets out alternative paths for the US Fed Funds rates, and how these map into alternative yield curves in Chart 4. The three different scenarios all lead to US 10 year rates in the range of 2-3%. Importantly, it takes quite an aggressive path for the US Fed Funds Rate to imply that US 10 year yields should be at the top of this range at 3%. So while over a long-horizon US 10 year yields may eventually settle at around 4%, in the meantime low cash rates should keep bond yields relatively anchored.
Consistent with this analysis, following a sharp rise in bond yields in May and June, the US 10 year rate settled at around 2.60% for much of July, as investors saw appealing value as yields approached 3%.
The RBNZ finally change their tune
While the Fed surprised the market in May and June with talk of ‘tapering’ QE, the RBNZ stuck stridently to its message that the Official Cash Rate (OCR) remains on hold.
However, the evidence of economic momentum has been mounting in recent months:
- The ANZ Business Outlook has firms’ Own Activity Outlook at a high net 45% positive.
- The Westpac Consumer Confidence index has risen to its highest level in 3 years.
- Net migration has lifted to its highest level in 3 years.
- New dwelling units authorized are at their highest level in 5 years.
- Auckland annual house price inflation is around 15%, its highest rate in 6 years.
- Fonterra had increased it projected payout for the 2013/14 season.
- The NZ Dollar Trade-weighted index has fallen notably from its 2013 highs.
This more upbeat outlook is also captured in NZ’s PMI, which remains elevated, well into the expansionary zone above 50 (Chart 5).
While the RBNZ decided to keep the Official Cash Rate (OCR) on hold at its July review, it made two material changes to its press release that recognise the strength of the economy.
First, in the important final paragraph they acknowledged that the “removal of monetary stimulus will likely be needed in the future”. This is the first time since Graeme Wheeler’s appointment that they have officially moved to a tightening bias. Previously, their statements had been more even handed, opening the door to either hikes or cuts.
Second, while they expect to keep the OCR unchanged through the end of the year, they have made clear that “extent of the monetary policy response will depend largely on the degree to which the growing momentum in the housing market and construction sector spills over into inflation pressures”. This is what economists call making their decisions “data dependent”. In layman’s terms, the RBNZ have sent a clear signal that they are reserving the right to put rates up sooner if economic data surprises on the upside in coming months.
The market is now placing a 50% chance of a 25bp hike at the RBNZ’s January 2014 meeting, with the OCR expected to rise to 3.0% by April 2014. By contrast, as the Australian economy has stalled in recent months, the market is expecting the RBA to cut its official cash rate towards 2.0% by mid 2014 (Chart 6).
Fonterra’s product safety issues announced at the beginning of August create a new risk to the economy1.
For fixed interest markets, it will depend on whether the threat to NZ’s export income (taking into account quantity and price impacts through a lower currency) is material enough to affect overall growth. This is very hard to judge so soon, and will depend in part on how much the currency works as a shock absorber. Following the announcement the NZ dollar fell around 1.5% to near lows for 2013.
Over July, global fixed interest markets calmed, with yields broadly unchanged.
It now seems that it would take a real downturn in US data to prompt the Fed to completely step away from tapering QE. We think that we would need to see much weaker data or re-emergence of global stress to get US 10 years bonds back towards 2.0%.
Equally, while the US Fed remains committed to keeping US overnight rates near zero for the next few years, it becomes more difficult for US 10 year yields to rise significantly above 3%.
On balance, we judge that there has been a further improvement in economic momentum in the US and New Zealand. Furthermore, Europe is moving from a basket case into economic recovery, and there is scope for Australia and China to exceed the pessimistic expectations of markets.
So looking beyond the immediate risk of Fonterra’s product safety issues, over the medium-term we continue to see sufficient global and domestic economic momentum to support higher bond yields.
1 Harbour Navigator: “Wheying up contamination risks” – 5 August 2013.