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Don't allow deflation doomsayers to dissuade you from prudent risk management of interest costs, says Roger J Kerr

Bonds
Don't allow deflation doomsayers to dissuade you from prudent risk management of interest costs, says Roger J Kerr

By Roger J Kerr

Some sense of reality is finally returning to the US long-term interest rate market that directly determines our market interest rates in New Zealand from three years onwards.

Up until a few weeks ago, non-economic global events had caused US 10-year Treasury Bonds to reduce in yield from 2.75% mid 2014 to rates below 1.75% earlier this year.

US economic factors took a back seat over this period as investor demand for the security and safety of US Government bonds drove the yields down.

The US 10-year yields have reversed upwards over recent weeks as jobs growth in the US economy continues at a buoyant clip and the concern at global geo-political risk events dissipate.

Last Friday’s strong increase of 295,000 in employment for February spurred 10-year Treasury Bond yields up from 2.05% to 2.25%.

The bond market at least recognising that a stronger labour market leads to wage increases and thus some inflationary pressures. The strong data keeps the Federal Reserve on track to increase US short-term interest rates in July/August.

It is difficult to see US long-term interest rates going back down again against an environment of increasing short-term rates over the second half of this year. Our 10-year swap rates at 3.90% continue to lag the 65 basis point increase in the US bond yields over the last few weeks from 1.60% to 2.25%.

US long-term interest rates still have a lot further to increases on economic grounds and for this reason all borrowers in this part of the world should be fixing as much as they can for as long as they can.

Such borrowers should not allow the doomsayers (who promote global deflation as the thing that keeps NZ interest rates at the historical lows) to dissuade them from prudent risk management of interest cost.

The US and NZ economies may have very low annual inflation right now due to the unexpected plummet in oil prices, but the underlying and reasonably strong economic growth conditions means we are a long way from inheriting Europe and Japan’s deflation problems.

Even at current yields of 2.25%, US 10-year Treasury Bonds still appear far too low against the historical correlation to US annual core inflation rates (refer chart).

While the 10-year interest rates have traded as low as the core CPI (excludes food and energy prices) in 2009 to 2011, the super low bond yield levels never lasted. Prior to the GFC, US bond yields traded 1.00% to 1.50% above the core inflation rate.

Today the US economy is a very long distance away from GFC economic conditions. 

Daily swap rates

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Source: NZFMA
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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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1 Comments

Have you got the right hand scale correct? Its exactly the same as the CPI and I'm sure US treasury yields were higher than that at the turn of the century. http://research.stlouisfed.org/fred2/series/DGS10

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