US credit spreads widening, angst in high-yields. Local markets reduce bets on more OCR cuts

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NZ rates rose on Friday, while US Treasury yields steadily fell during the US trading session, with the 10-year rate down a chunky 10 bps from 2.23% to 2.13%.

The washout from the RBNZ’s “hawkish easing” on Thursday continued to impact the NZ rates market on Friday. The bank bill futures curve was up 5 bps in yield from June-2016 onwards, as the market reduced the chance of further rate cuts next year. 

The 2-year swap rate was up 4 bps to 2.78%, with rises of 5-6bps further along the curve.  As well as expectations of less easing next year, the upward move in yield also reflected traders and investors taking off long positions ahead of year-end.  With the RBNZ likely out of the picture for at least the next two OCR decisions, the risk-reward from holding received rates positions at the short end of the curve no longer seems attractive.

On our view of a prolonged period of monetary policy stability over the months and quarters ahead, global factors should have more influence on the NZ rates market. There should be downward pressure on NZ rates today, following a 10bp rally in the US 10-year. Even the US 2-year rate managed to rally, falling by 7 bps – ahead of the expected tightening by the Fed on Thursday – as risk appetite evaporated.

In the US rates space, while Treasuries have been range trading over recent months, credit spreads have been widening. 

The US firm Third Avenue Management suspended redemptions from its $788m Focused Credit Fund, a rare move for a mutual fund.  This reflected investors withdrawing funds in illiquid market conditions and an inability of the fund to meet investors’ needs without significantly impacting prices.  The high yield or so-called junk bond market has been under some stress recently, evidenced by spreads reaching their highest levels in about 3 years. Ironically, as investors ready themselves for the first Fed tightening in a decade, the yield on the Barclays US corporate high yield index is knocking on the door of 7% compared to 3.5% in mid-2014.

The current angst in the high yield space echoes early developments during the global financial crisis. Some trace the genesis of the 2007-08 GFC to August 2007, when BNP Paribas suspended redemptions from 3 investment funds because it couldn’t fairly value their holdings as US sub-prime mortgage losses filtered through credit markets.  We will be watching developments closely in global credit markets to how much further they deteriorate further.  Some wash-up from these influences on US Treasuries and the NZ rates market seems inevitable.

The FOMC meeting on Thursday will be closely watched. The probability of the first rate increase in more than a decade is running at around 75%, but the focus will be on how quickly the policy rates might be raised through 2016 and beyond.  The tone of the Statement will be influential in setting the scene for the likely path of US Treasuries and NZ long bond and swap rates over the coming year.  We expect tighter US monetary policy through 2016 will raise US bond rates and this will feed through into the NZ curve.

Kymberly Martin is on the BNZ Research team. All its research is available here.