Credit spreads continue to unwind

Local risk premiums back to pre-Brexit levels. Good local data pushes likelihood of more RBNZ easing back. Economists expect the UK to fall into recession

Bonds

Local risk premiums back to pre-Brexit levels. Good local data pushes likelihood of more RBNZ easing back. Economists expect the UK to fall into recession

1st Jul 16, 8:10am by Jason Wong

By Jason Wong

Despite the risk-on mood, global bond markets are well supported on the expectation of further monetary policy easing.

BoE Carney’s message that further policy easing will likely be required has driven the UK 10-year rate down to 0.86%, a fresh record low. The UK OIS market prices in a 62% chance of a 25bps cut in July, and almost a 100% chance by August. In a Bloomberg poll, 71% of respondents believed that the UK would enter an economic recession.

US 10-year Treasuries have traded in a wider than usual range overnight of 1.45-1.54%, to be down 4 bps at present to 1.48%. The shape of the curve shows a mild flattening, with the 2-year rate down 6bps at 0.58%, on track for its lowest close since October. Rate cuts are no longer priced in the curve, but the market’s view is that any prospect of tighter monetary policy is way out in the distant future – one full rate hike is not priced into the curve until late 2018, more than two years away.

Credit spreads continue to unwind their immediate post-Brexit vote sell-off. Australia’s Itraxx CDS for investment grade bonds, at 127 bps, is essentially back to the levels it traded before the vote.

The local rates market has been quiet in the aftermath of the Brexit vote, with offshore players focused elsewhere. There was mild upside to local rates yesterday, but we’re likely to see a reversal of that following offshore moves overnight. The 2-year and 10 year swap rates closed at 2.23% and 2.66% respectively.

The strong ANZ business outlook survey had no market impact. Activity measures pointed to some recent upward momentum in the economy, while inflation expectations showed further sign of lifting from recent depressed levels. In combination with other recent data, it raised further doubts about whether the RBNZ would deliver further easing in August. The OIS market still prices that meeting at close to 50/50. BNZ economists remain over the line for a 25 bp cut, but continue to assess the probabilities carefully.

While economic data are less important for the market in the wake of the Brexit vote, over the next 24 hours there’s a number of key releases worth keeping an eye on including Tankan and CPI data in Japan, PMI data for China and the ISM indicator in the US.

Daily swap rates

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Source: NZFMA

Jason Wong is on the BNZ Research team. All its research is available here.

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2 Comments

by ham n eggs | 1st Jul 16, 8:51am 1467319907

IM surprised any bank needs a research team now - its pretty obvious. Rates will keep going down until the system breaks - there is NO possible way any economy can handle a rates rise without sending producers bust and the debt overhang is only growing...

by Stephen Hulme | 1st Jul 16, 9:36am 1467322609

BoE Carney’s message that further policy easing will likely be required has driven the UK 10-year rate down to 0.86%, a fresh record low.

The persistent transfer of wealth to the already wealthy bond holders, underwritten by the expectation of future fixed coupon bond payments, funded by taxpayers suggests something is amiss with previous rate cut outcomes, given asset revaluations are generally the only beneficiary of central bank stimulus threats.

Though central banks purport to follow something like Knut Wicksell’s natural rate theory, in reality they have changed it around such that everything is viewed via the “demand” side; and thus nothing actually makes sense including the behavior of market interest rates.

This is what Milton Friedman called the interest rate fallacy, and it indeed refuses to die. We can tell what monetary conditions are in the real economy, as opposed to financial liquidity, though the two can be linked, by the general level of interest rates. When money is plentiful, interest rates will be high not low; and when money is restricted, interest rates will be low not high. The reason is as Wicksell described more than a century ago:

[The natural rate] is never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.

When nominal profits are expected to be robust, holders of money must be compensated for lending it out by higher interest rates. Thus, the same holds for inflationary circumstances, where nominal profits follow the rate of consumer prices. During the Great Inflation, interest rates weren’t low at all, they were through the roof well into double digits and higher by 1980. At the opposite end in the Great Depression, interest rates were low and stayed there because, as Wicksell wrote, the rate of profit was low and was expected to be low well into the future. High quality borrowers were given as much money as they could want while the rest of the economy was deprived of funds; liquidity and safety being the only preferences in what sounds entirely familiar. Read more