By Roger J Kerr
When future movements in financial markets become “sure bets” one starts to get worried about the risks surrounding the consensus views and pricing.
Such is the case with our short-term interest rates with 2.00% of increases for the Official Cash Rate already well-priced into the market two and three year swap rates. The risks to the “sure bet” revolve around the Reserve Bank of New Zealand being forced by the weight of evidence to increases interest rates earlier and higher or alternatively lift the rates at a slower pace than what the market expects.
I would favour the latter as the greater risk as I doubt that the NZ economy is going to perform over the next 12 months in excess of the already hyped-up expectations currently dominating the sentiment.
Therefore, what are the risks or economic/market developments that could force the RBNZ to re-assess and adjust to a slower pace of OCR increases?
• Wholemilk powder prices decreasing at a much more rapid rate than currently expected across the dairy industry.
GDP growth would be below forecast if dairy prices plummeted, however the NZD/USD exchange rate would follow and partially offset the negative impacts in terms of rural incomes. Fonterra will have sold forward next nine months of wholemilk powder supply and hedged the currency as well. So a delayed impact, however nevertheless a significant negative for the overall economy. A much lower NZD/USD exchange rate would increase tradable inflation, so the RBNZ would have to be careful about pulling back on OCR increases.
• A reversal in the direction of house prices caused by increases in mortgage interest rates having a more pronounced impact on the property market than what most envisaged.
The LVR restrictions have already slowed the number of house being sold this year, which tells you that buyers are prepared to be patient and are less concerned about prices running away on them. Over time, sellers, if they are serious about selling, will adjust their price expectations lower. No different to any other market really.
• The global economy encountering more humps in the road in terms of GDP growth and thus demand for what we produce in New Zealand.
Global economic risks are centred on Chinese growth slowing at a much slower rate than generally expected. Over the weekend a major Chinese solar power equipment manufacturer, Shanghai Chaori Solar, defaulted on interest payments on its domestic bonds, which might be something of a test-case to see to what extent over-leveraged Chinese companies are rescued by Beijing. So far, there is no sign of any Government bail-out.
A 0.25% OCR increase this week is a foregone conclusion, however attention will be on the updated RBNZ economic forecasts and to what extent those upbeat numbers are tempered by the risks such as the three listed above.
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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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