'Interest rate market too complacent on inflation'

Bonds

Inflation doves need to look beyond low historical numbers, says Roger J Kerr

12th Jan 15, 12:51pm by Roger J Kerr

<a href="http://www.shutterstock.com/">Image sourced from Shutterstock.com</a>

By Roger J Kerr

If the local interest rate yield curve was a cricket pitch it would be labelled a “flat-track” that any team could bat all day on and not lose a wicket.

The very flat shape of the yield curve is however not a reflection of the NZ economy and the related inflation outlook. It is merely a combination of two un-related interest rate markets, the RBNZ determined short-term rates out to two years and the US bond market dictating the swap rate levels from two years to 10 years.

The latest decrease in US 10-year Treasury bond yields to below 2.00% has pulled our swap rates even lower with 10-year swaps rates pushing below 4.00%.

Lower oil/energy prices and continuing deflation/money printing in Europe has encouraged global investors to seek the secure and safe, but now very low yield of 2.00% in US Treasury bonds. The decrease in US bond yields is at odds with all the leading economic indicators in the US economy which point to strong GDP growth and the inevitable higher inflation that goes with that economic expansion.

In both the US and New Zealand we are witnessing tightening labour markets with no evidence (yet) of that market’s supply/demand equation producing higher wages that eventually feeds into inflation. Like all markets, the price response (wage rates) may be delayed where the supply/demand equation is out of balance, but it does not disappear altogether.

It would be foolhardy, in my view, to argue that the world is a different place now and wages are not bid up when there is a supply shortage and a stack of demand. Watch this space for evidence of increasing labour costs in both NZ and the US as the year of 2015 progresses.

Other inflation pressures on the horizon over coming months include higher telecommunications charges, higher imported consumer goods due to the lower NZD/USD exchange rate and rising house rentals in the major population centres of Auckland and Christchurch. Offsetting those price increases at the headline inflation level will be lower petrol pump prices.

The RBNZ has a policy to “look through” first round oil price shifts that are beyond its influence in terms of forecasting and controlling inflation. Therefore it is difficult support the view that the RBNZ should cut interest rates rather than increase them this year because annual inflation is 1.00% and destined to stay there.

Global investor sentiment that is pushing long-term interest rates lower right now can change rapidly and at some point the economic reality of strong growth and related rising labour costs will send our market interest rates back up.

The mood of the local interest rate market has moved to now being far too complacent on the inflation outlook. The early December Monetary Policy Statement was a timely reminder to the market doves that the RBNZ does look a bit further ahead than historical actual inflation figures.

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Source: NZFMA

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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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23 Comments

by rastus1 | 12th Jan 15, 1:22pm 1421022164

It would be foolhardy, in my view, to argue that the world is a different place now and wages are not bid up when there is a supply shortage and a stack of demand

Not so sure. The world is awash with indviduals seeking employment - many very skilled. They may not live here, but are more and more accesable via internet. As an example, take a look at Gilligan Shepherd http://connection.ebscohost.com/c/articles/36978907/nz-accounting-firms-outsourcing-success-story

There will be many more doing similiar..wage rsies will be limited to the very few..

by Keyser Söze | 12th Jan 15, 2:52pm 1421027558

I sort of feel like RJK and the rest of the inflation hawks have been saying this for years upon years and have been wrong for years upon years now. Keep saying it and eventually sure enough they will be correct.

The NZD is down yes but only at 78c so imported inflation won't come running in especially as hedges are still in place. More critically the NZD landed cost of petrol is down. Inflation expectations per RBNZ survey intentions and others are low. The BNZ are warning of deflation.

Yes inflation was tramatising to all who experienced it the decades previous to this one but it is clouding otherwise bright minds.

by steven | 12th Jan 15, 3:29pm 1421029794

I will watch this space as I have for the last 7 years and watch you consistantly get your inflation calls wrong. So in terms of strategy, based on your predictions, well um no....oopsie.

Eventually it is possible maybe 5~10 years from now we'll see inflation, it is what is going to go on in-between that matters today. So before your eventual inflationr I strongly suspect we'll have seen a nasty dose of deflation globally, just how NZ avoids that is the Q.

"the world is a different place now" Thats just it, it is we are going where humans have never really gone before, less energy.

by skudiv | 17th Jan 15, 6:17pm 1421471872

Suprisingly Steven you have been closest to right in your predictions re. liquidity traps et al. Still holding cash?

by steven | 17th Jan 15, 8:51pm 1421481067

Ive not held actual cash, no.

and not my predictions, more like those of Steve Keen and Paul Krugman. As Pk said V the Wall Street journal, if you had listened to them and not me you would have lost a lot of money.

So really find goof ppl to listen to is my suggestion.

by Simon | 12th Jan 15, 4:00pm 1421031648

Whats your pay rate roger? 500-600+ per hour? You honestly recon u are that good, are worth that much, predict the future that much better than anyone else?

by Grant A | 12th Jan 15, 6:09pm 1421039396

Simon I think you'll find, as in this article, what Roger's talking about almost all of the time is RISKS. Risks as to what can happen, and unless you actually think that all economists, commentators and bloggers themselves know what;'s going to happen, its risks that we should be almostly totally focused upon.

Certainly low inflation forever is something the market is hugely complacent about (and you can see from the likes of Steven's comments above, all and sundry have that view - its hugely mainstream ), but that doesn't mean they'll be proved right or wrong, but often they are wrong, and those risks, the ones that noone acknowledged but a few, suddenly materialise to bite you in the arse - highlightling complacency is very useful as often the one-eyed man doesn't see it. I just love reviewing what people forecast here at the start of the year and what that review shows of their forecasting ability - the smarts ones have started to become vague, not surprisingly as all it goes to prove is that no one knows and many are quick to forget what they have said previously but are still quick to critcise others forecasts.

by Stephen L | 12th Jan 15, 6:21pm 1421040094

Roger does not really make the case for the risk of inflation on the horizon very well. He talks of inflation being at 1% when that was its most recent score, but it would seem very likely to go significantly lower than 1% over the next six months. Any suggestion of imported inflation based on a small appreciation against the USD is nonsense. The TWI is close to all time highs. Nearly all commodities, not just oil, are at decade low prices. Many of our manufactured imports are from China, Japan and Germany. They have nil inflation and plenty of spare capacity, and are using commodities at very low prices in their manufacture.

Having said that I would not necessarily advocate lower interest rates, but I would advocate measures to encourage the exchange rate down, otherwise there is a somewhat certain risk in the future of a forced rather sharp devaluation which will cause some issues; while the high exchange rate now is surely causing wrong industry incentives, and indusrty dislocation, as well as the loss of wealth associated with a high current account deficit.

Without either lower interest rates or measures to lower the exchange rate, I'm not sure how the RBNZ could plausibly explain how they are going to meet their current Policy Targets Agreement with the Minister of Finance.

by steven | 17th Jan 15, 9:00pm 1421481620

So how to you push the exchange rate down? print?

by Stephen L | 17th Jan 15, 9:17pm 1421482640

Some of the following options seem in common use by foreign countries:

Buying foreign assets. The choice of asset can be important, as I understand it.

Buying your own government bonds, potentially to fund some of any fiscal deficit.

Potentially funding any domestic commercial bank funding needs by direct funding at competitive interest rates, in lieu of them seeking foreign funding.

Working with the government to tighten foreign buying of NZ assets.

Your favourite- drop interest rates.

Through some testing and learning, invest reasonable amounts in some or all the above, and test the effect. Keep going until you reach the desired levels of exchange rate and or inflation.

by cowboy | 18th Jan 15, 6:11am 1421514665

Steven, you know what we were told all the last half of last year...

If you push the exchange rate down it will cost everyone more because it will make fuel prices go through the roof.,...

by steven | 12th Jan 15, 7:17pm 1421043425

The trouble is his risks are one sided, he never mentions deflation or the 3rd stagnation, instead has for 7 years harped on about (I assume significant) inflation which has not materialised.

Lets look at what you can do about and comment on inflation,

a) oh simply rise the OCR its pretty effective in dousing inflation even if applied late, ergo it is containable, once you are sure it exists.

b) Its keynesian mainstream maybe but not what Govns and indeed many economists and right wing Pollies and lots of them have been saying for years so, no actually not mainstream, the opposite.

c) What we do have maybe finally is a swing away from the die hard right and austrians who it seems are finally being put out to pasture as they fail again and again in shouting "inflation!!!!!!"

Lets look at what we can do about deflation,

a) Once in it its very hard to get out of.

b) Appears to be in some sectors/countries (eg Spain) and not others and those sectors/countries failing will bring down the house of cards.

BTW, Can you point me at some articles where roger shows a balanced view of the risks? I dont recall one serious discusion of his on it.

So on the one hand we have a risk (inflation) that wont be significant initially, can be delt with easily if a bit painfully and on the other deflation that will be painful and and hard if not impossible to deal with.

"vague" sure, the ability of the system to soldier on despite the best efforts to knee cap it by the right have been amazing frankly. However for 8 years what we (as in globally) have not done is recover significantly, we have at best just staggered along.

===edit===

PS, I dont recall deflation being mentioned here really at all by a journalist/commentator to balance the inflationistas side of the argument.

by Simon | 13th Jan 15, 7:46am 1421088362

Risks are probabilities, probabilities are predictions.

Until you quantify a risk it's not much use from a decision making point of view.

Welly has a risk of earthquake. So what. Welly has a 1% risk of a big quake in next 10 years. Now we can factor this into decisions, i.e assign little value to the risk.

by cowboy | 18th Jan 15, 6:13am 1421514802

There was an Earthquake in Chch, now many billions are being spent reinforcing buildings everywhere else. Where is the quantification process there?

They play by different rule book, not a business one.

by steven | 17th Jan 15, 8:59pm 1421481548

I like to talk about risks and impacts, however you have to consider all risks and impacts and just not a ones taht go along with yoru economic/political outlook which Roger has.

Currently the Swiss may have slit their own throats or at least many of their businesses, the EU looks to be going into deflation and the US's "growth" taht was substantially shale oil driven is looking aneamic.

Meanwhile china and indeed the world isnt buying our milk at a price our over-indebted farmers need, but we are bound to have significant and prolonged inflation, I think not, not today anyway, maybe 5, possibly 10 or maybe 20 years from now. Just consider its 2015 and we have been at this 6 years and its looking worse not better.

by Grant A | 12th Jan 15, 8:01pm 1421046066

I can't argue with alot of that Steven, especially as I think it's quite likely we'll see a couple of quarters of negative CPIs (but I strongly doubt annual deflation but anything's possible), and yes the mainstream has expected some modest inflation to return which equally will probably be right but certainly not in the time frame originally expected. It is something that he's favoured without question but as far as rate hikes are concerned, he's been right about that risk, and obvious that was a total surprise to the few rate cut protagonists in here who wouldn't listen to that risk and who were wrong by about 150 basis points so far. Personally I don't think anything is going to happen as expected by anyone in either camp, its quite possible we'll actually see both.

I have said all along that when you have 7-8 years of negative real interest rates and money printing, in pretty much all the major economies of the world, uncertainty and volatility is the one thing, possibly the only thing, that you can be certain about. Already we are seeing developing situations far removed from the norm driven by totally unsynchronised monetary policies of those major nations where strong growth gets you a rallying bond market, where asset markets are propelled higher almost solely by central bank liquidity, where the velocity of money has collapsed, where countries are racing to devalue their currencies, where consumer inflation is low and interest rates the same as a consequence, yet assets markets are getting out of control and unable to be moderated by conventional means - and that's only naming a few as you'll be aware. Anyone who thinks they know how that pans out when its not be seen to this extent in the history of mankind, is frankly delusional - we can guess, but we have to understand the risks to any specific view as they are huge.

by steven | 12th Jan 15, 8:38pm 1421048288

What I note is yes there are risks, but there are other risks besides inflation, now if he was covering these in a logical manner OK.

Petrol may well cause some extremely anemic CPI's and hence why I like core that has energy removed.

Hikes right? now in predicting the RB would do it, yes, but then so was just about evreyone else. But should it have been done? I dont agree, we have put up the OCR and the modest indiction 1.6%? disappeared rather quickly.

I'l agree the RB should be looking through petrol, in fact ignoring it on the upside and downside.

here is the reasoning,

http://krugman.blogs.nytimes.com/2015/01/07/panic-fast-and-slow/?module…

"The same logic that made me ignore the inflation bulge when oil was going up says to ignore the dip from plunging oil."

Sure its the EU, but its way easier to see that long term disinflation trend from core and ignore the blips that proved to be false indicators in CPI.

And false indictors brings us back to Roger...

by steven | 12th Jan 15, 8:23pm 1421047428

telecoms higher? why? Im looking at dropping prices and more volume as well.

rents except for chch are reported as flat, why now will they finally rise? people have no more money to pay.

Wage rises? hmm really...

by ACB | 13th Jan 15, 1:25pm 1421108708

I think the debate here is interesting and I think both sides could be right. Because of what has happened post GFC, the prospect of higher inflation or deflation is now greater than it has been in many years. In otherwords there is greater uncertainty about the future path of inflation.

And let's lower the importance of short term impulses like volatile petrol prices - the important thing to focus on is long term inflation, on average, i.e. the next 10 or 20 years. That is driven by the global economy, central bank and government policies and more micro things such as wage negotiations etc.

Then you need to think about which scenario hurts you the most. If you are an investor, it is likely that unexpected inflation will hurt your nest egg more, a borrower will be hurt more by deflation. It follows on that you may need to protect yourself more from one outcome than the other even if you assign it a lower probability. Historically, inflation has been more common than deflation since the introduction of fiat money.

I think the key question is how do investors prepare themselves for this uncertainty? A deflationary scenario without growth e.g. Japan, is best countered by an investment in nominal bonds. Conversely a stagflationary scenario of weak growth and higher inflation e.g. 1970's early 1980's UK, NZ is best reflected in investing inflation linked bonds. Where there is also growth then property and real assets also make sense.

by earl white | 13th Jan 15, 1:49pm 1421110162

Roger accused me of a "smart arsed comment" on this site some time ago when I said on a plane to him "still waiting for the inflaiton bubble Rog" ...well you are still waiting I see Rog ....pity about some of the policy maximum fixed rate hedging done over last five years in anticipation

As a proper risk manager I find Roger's ongoing (usually wrong ) big calls rather amusing but risk managment is all about balance and making sensational calls to get quoted in the press in my view does little to add real value to the ongoing desire to help NZ inc manage its financial risks properly .... we have enough bank economists as talking heads ... at least man up Rog and admit over last 5 years you have got it horribly wrong !

by earl white | 13th Jan 15, 1:49pm 1421110169

by Stephen Hulme | 13th Jan 15, 2:33pm 1421112780

Hmmmm - I commented: The Auckland Council lost NZ$233 million after tax in its first full year of operation with the lion's share of the loss blamed on unrealised costs stemming from fixing future interest rates at current low levels.

...include NZ$167 million stemming from the unrealised costs of contracts to fix future interest rates at current historic lows Read more

I know not which firms were the advisors to the outcome, but it seems Mark Butcher, the incumbent council treasurer at the time, moved on to head up LGFA.

by cowboy | 18th Jan 15, 6:09am 1421514551

they lost that much mostly from _interest_ overruns?

and people say agriculture is ove leveraged