Roger J Kerr sees business-as-usual post election, with the NZD weakening, exports and investment rising, and inflation risk higher. Interest rates are going up

 By Roger J Kerr

How businesses, investors and households behave in the NZ economy now that the uncertainty of the election is out of the way will determine how and when interest rates change over the next 12 months.

Contrary to what many believe, it is not the banks or really even the Reserve Bank that determine the direction and level of interest rates over time.

It is the combined decisions of all investors and borrowers that drives the price of money - that is, interest rates.

If all borrowers (household and corporate) believe the economy is going to be stronger in the future and that inflation will increase then they will all fix their interest rates now and that demand will force fixed-rate wholesale swap rates to increase.

If investors (institutional and retail) believe that the economy is going to struggle and thus inflation decrease in the future than their combined decisions to invest for longer terms will force interest rates downwards i.e. the weight of money forcing lower rates.

I do not think anyone sees lower inflation in the NZ economy in 2015, therefore the debate is centred on the timing and extent of interest rates increases.

Our longer term interest rates from three to 10 years will be determined (as always) by the direction of US 10-year Treasury bond yields over coming months.

The market factors influencing the US bonds are viewed as follows:

- How and when the US Federal Reserve change their wording on the timing and extent of increases in their short-term interest rates in 2015 now that QE bond buying is all but finished?

- At what point do global investors who purchased US Treasury bonds over recent months for safer-haven reasons on geo-political concerns unwind their holdings and become bond sellers (forcing yields higher)?

- Will the stronger US economic data continue? Manufacturing and housing data should again be positive this week, supporting the overall improvement in employment and business investment in the US economy. US GDP growth for the June quarter will be revised higher to 4.7% (annualised) this week.

While the local short-term moneymarkets are pricing no change to the OCR until mid-2015, the economy is not going to be that static over coming months.

Businesses and households will be relieved that their decisions will no longer be influenced by uncertainties over taxes and government economic policy direction.

Once the election euphoria is forgotten about by the financial markets it will be business as usual.

A weaker NZD/USD exchange rate below 0.8000 will be good news for investment and growth in the export sector, albeit tradable inflation will eventually increase once importer hedging runs off.

The interest rate yield curve still has the potential to steepen abruptly over coming months as US bond yields move up by 40 to 50 points, thus pushing up our longer-dated swap rates with no change to the 90 day to two year interest rates. 

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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