US and European treasury auctions well supported. England prepares for a rate cut. Local swaps curves steepen. RBNZ facing low inflation for longer

By Jason Wong

Following, yesterday’s significant sell-off, US Treasuries have been well supported.

After reaching a peak of 1.53% early yesterday morning, it’s been a steady move lower for the 10-year rate and it currently trades at 1.46%, down 5 bps on the day and down a couple of bps since the local close.

A 30-year Treasury auction this morning was well bid, with indirect bidders (which includes foreign central banks) showing increased demand.  Much of the financial press has highlighted the negative-yielding 10-year bond auction in Germany overnight.  Germany became the first euro-area country to issue 10-year debt at a negative yield, selling the zero-coupon bond at minus 0.05%.  If this sounds like a poor investment, then it is, but any buyer could have sold it at the close and yielded a profit, with Germany’s 10-year rate down 6 bps on the day at minus 0.09%.  Switzerland and Japan are the other two countries that have issued 10-year debt at negative yields.

UK gilts showed some of the largest falls, with the 10-year rate down 8 bp to 0.74%.  OIS pricing shows an 82% chance of the Bank of England cutting its policy rate by 25 bps to 0.25% tonight.  Surveyed economists are a bit less convinced than that but acknowledge that a rate cut either tonight, or delayed until next month, is highly likely.  There will be some interest in other stimulus measures the BoE might choose to adopt as well, such as further quantitative easing or an expansion of its “funding for lending” scheme, which incentivises banks to increase new lending.

Yesterday, the local rates market followed offshore moves, with a steepening the yield curve.  The 2-year swap rate was unchanged at 2.24%, while the 10-year rate rose by 6 bps to 2.61%.  The 2-year rate managed to hold its ground suggesting that the market wasn’t willing to give up on the prospect of further RBNZ easing.

NZ’s food price index for June showed a smaller than usual increase for the start of winter and for the year was down 0.5% y/y.  Combined with recent falls in petrol prices, CPI inflation is looking to come in much lower for Q2 and Q3 than we previously thought, at 0.6% and 0.3% y/y respectively.  Add in the likely deflationary pressure from a stronger-for-longer NZD and the RBNZ will be struggling to get inflation back within the target band by year-end and inflation is looking to come in well south of the mid-point even by the end of next year.

The August MPS will be interesting because the RBNZ will have to come clean on its reaction function.  If it doesn’t cut the OCR and show further rate cuts ahead in an attempt to generate higher inflation pressures then that would effectively reveal an abandonment of its inflation target.  Despite increased client enquiries wondering about the latter, the RBNZ speech last week suggested that “…the outlook for CPI inflation will ultimately determine the future path of monetary policy”.  We’re still backing that the RBNZ will keep to that word and believe that an August rate cut remains the most likely course of action.