By Roger J Kerr
The local interest rate market would like to price interest rates higher as the current and future strength of the NZ economy dictates that inflation will be increasing in 2014 and interest rates need to be higher to cool off those pressures.
However, there are two inter-related variables at work that are, for the meantime, preventing interest rates from increasing:
1. US 10-year Treasury bond yields (that drive our term swap rates from three years to 10 years) have not returned to the previous 3.00% level they reached in May/June when Ben Bernanke first announced that the Federal Reserve would start to taper back bond buying/QE monetary stimulus.
More recent statements from incoming Fed boss Janet Yellen suggests the hurdle may be a little higher in terms of improvement in the US economy/jobs before the Fed considers tapering.
The bond markets still has worries about the US Government fiscal deficit/debt situation and a failure by the politicians to reach agreement by critical dates in mid-December and mid-January would see QE extended further to compensate and 10-year bond yields staying down at 2.70% for a while longer.
2. The NZD/USD exchange rate comfortably above 0.8000 due to a weak USD already has monetary condition in New Zealand on the tighter side of neutral, therefore economic dangers for the RBNZ to lift short-term interest rates.
Governor Wheeler still has to hope that global FX markets do mark the USD stronger over coming months which will drive the Kiwi down below 0.8000 to provide the window for OCR hikes.
The USD will only strengthen if US economic data prints stronger than expectations, so we come back to the same catalyst for change as the US bonds as described above.
The NZ inflation genie may get too far out of the bottle if the US economic data does not improve and the two variables at work described above stay as they are.
In this scenario, Governor Wheeler would have to tighten monetary policy harder in the second half of 2014 if the US bond/currency situation prevents him from commencing in March.
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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
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