Roger J Kerr says it is a mistake to assume NZ will 'always' follow Australia; divergence risk is unusually high at present

 By Roger J Kerr

A comment from a Board director of a new client this week about NZ interest rates always following Australian interest rate movements and therefore there was no hurry to fix as Australian interest rates were going down, reminded me of the dangers of relying on market correlations always holding and therefore a  “no worries” risk management approach.

The professional director in question use to head one of New Zealand’s major companies so his view needed to be taken into seriously.

However, right now the NZ and Australian economies are heading in different tangents and the divergence in direction of our two-year swap interest rates and thus rising NZD/AUD exchange rate proves the point.

The integration of the two economies and closeness of our banking and financial markets does mean there is a natural linkage between the interest rate markets.

Any correlation that may have existed has broken down over recent months as the NZ economy steams ahead on high milk and house prices, while the Aussie economy wallows in doubt and uncertainty (some of which is self-inflicted by political changes and risks).

Over recent months NZ two-year swap rates have increased from 2.60% to 3.35%, whereas Aussie two-year rates have reduced from 3.25% to 2.55%.

Concluding not to hedge NZ interest rate risk because the view is that Australian interest rates are going lower seems a dangerous strategy currently.

Normally correlated financial market variables de-linking is just the type of financial risk that needs to be proactively hedged, otherwise the diverging price action can bite you in the backside.

The first issue to recognise is that the Australian and New Zealand economies are out of synch with each other and thus the risk of divergence is high.

The RBA will cut their OCR by 0.25% tomorrow, Tuesday 6 August, however the market is already pricing in reductions of 0.70% over the next 12 months.

Once the 6 September election is out of the way, I would expect Australian economic data to start to improve as they receive the benefit of lower interest rates and the lower AUD exchange rate over recent weeks.

The prudent interest rate hedger will not only be fixing higher levels of NZD debt right now, but also starting to lift AUD interest rate hedging as well as it is always easier to hedge on the way down than to attempt hedging decisions when the market direction in interest rates is up. 

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Roger J Kerr is a partner at PwC. 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