Multiple scenarios for future interest rate movements

By Roger J Kerr

There are a number of future interest rate scenarios gaining currency in terms of their probability of turning into reality over the next 12 to 24 months.

Borrowers and investors who are at risk to future movements in 90-day and term interest rates need to base their decisions and risk profile to the markets on the balance of probabilities attached to these potential scenarios.

While formulating scenarios and allocating probabilities is more of an art than science, it is a useful methodology to manage risk threw the minefield of local and international economic events and price changes.

Senario One

Roger’s probability of occurrence - 30%

Economic and Market developments:
1. Global investment markets settle over the rest of 2010.
2. US economic data is stronger and US 10-year T/Bonds increase in yield to above 4.00%.
3. NZ GDP growth over 4% for 2010. Consumer spending lifts.
4. RBNZ become concerned at “second-round” inflation impacts from 2010 one-offs.

Impact on NZ interest rate levels and yield curve shape:
1. Short-term rates increase earlier and higher than currently priced, climbing to above 5.50% in early 2011.
2. 10-year swap rates increase to above 6.25%. 

Senario Two

Roger’s probability of occurrence - 20%

Economic and Market developments:
1. Global investment markets remain volatile, sharemarkets fall over the rest of 2011.
2. Global growth revised down, commodity prices and Australasian currencies fall somewhat further.
3. US T/Bonds remain at 3.00%.
4. NZ’s commodity prices fall.
5. No second round inflationary impacts and the NZ domestic economy remains very flat.

Impact on NZ interest rate levels and yield curve shape:
1. Short-term rates increase later, and not as far as currently priced into the yield curve.
2. 90-day rates only increase to 4.50% and longer term rates reduce from current levels.

Senario Three

Roger’s probability of occurrence - 10%

Economic and Market developments:
1. The European contagion spreads to Asia and the world economy falls into a second wave recession.
2. Commodity prices collapse as Asian demand plummets.
3. The double-dip recession hits the NZ economy and credit dries up.
4. Inflation plunges to below 1.00% in 2011 after the spike-up in late 2010.

Impact on NZ interest rate levels and yield curve shape:
1. The RBNZ cancel their plan to return monetary policy from loose to neutral.
2. Short-term rates do not rise to above 4.00% and term swap rates decrease significantly from current levels.
3. Long-term swap rates fall to below 5.00% as US T/Bonds move below 3.00%.

Senario Four

Roger’s probability of occurrence - 40%

Economic and Market developments:
1. The global picture is not as positive Scenario 1, however not as negative as Scenarios 2 and 3.
2. NZ’s commodity prices stabilise just below current high levels.
3. Inflation settles at around 2.00% after the 2010 spike.

Impact on NZ interest rate levels and yield curve shape:
1. Short-term rates move up to 5.00% as the current yield curve indicates.
2. Long term swap rates move only marginally higher.

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 * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com