Roger J Kerr looks at the underlying reasons long term base rates and related spreads are set to increase

 By Roger J Kerr

There are not many doubts in the financial markets, the RBNZ, the Government, fixed-interest fund managers and amongst large and small borrowers that New Zealand’s short-term interest rates are going to go up by at least 2% over the next two years.

The interest rate market are pricing in 90-day rates to trade between 4.5% and 5.0% in two year’s time and these levels are consistent with RBNZ indications that the new norm for “neutral” monetary policy settings is around these level.

However, where might the five to 10-year swap rates be in two years’ time?

That comes down to your view on where the US Government 10-year Treasury Bonds will increase to, what margin our 10-year Government bonds trade above the US bonds and where margin there will be between our 10 year swaps and 10-year bonds.

On the assumption of increasing US GDP growth, increasing US inflation and increasing US short-term interest rates by early 2016 it would be fair to estimate the US 10-year bond yields could increase by 1.3% from current levels of 2.7% to 4.0%.

Added to that will be spread or margin that NZ Government bonds trade over US bonds. Historically, that bond spread has had a high correlation to our short-term 90-day interest rates as the chart below confirms.

My explanation of why the bond spread generally follows our 90-day rates is that foreign investors into NZ bonds tend to buy more aggressively when all interest rates are falling as they pick up an extra running yield over and above US 10-year Treasury bond yields.

That demand drives the US/NZ bond spread down. Likewise, when the same investors are selling out of bonds in a rising interest rate environment they will sell NZ bonds at a higher spread as they do not want to be in a small and generally illiquid periphery bond market.

In a rising interest rate environment NZ bonds have to be offered at a higher margin above US bonds to attract any buyers.

On the basis that NZ 90-day rates increase to 5% in two years’ time, the bond spread is likely to increase from the current 200 basis points to 250 to 275 basis points.

Therefore, in two years’ time our 10-year Government bond yields are destined for 6.5% and thus our 10-year swaps 50 points higher at 7%.

It looks somewhat extreme, however it makes fixing via swaps at 5.1% for 10 years today seem maybe not so silly after all.

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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