Fundamentals support demand for NZ Government bonds which are now outperforming equivalent swaps. BNZ sees Nov and Feb OCR cuts to 1.50%

By Kymberly Martin

NZ bond and swap yields declined and curves flattened yesterday.

Overnight, core offshore yields traded in a slightly lower range, with US 10-year now at 1.53%.

NZ swaps headed lower from the open, taking their cue from the slump in offshore yields the previous night. However, the decline in short-end yields appeared to be curtailed late morning by the release of Q2 NZ manufacturing activity data. This came in well above expectation. The strength was enough for us to lift our pick for Q2 GDP growth (due next Thursday) to 1.2%q/q, or 3.7% on an annual basis. If delivered, we believe this could see NZ short-end swaps push higher (NZ 2-year swap closed at 1.99% yesterday).

This could set up a better receiving opportunity ahead of the release of NZ Q3 CPI on 18 October. Our current forecast is for just -0.1%q/q. It will likely remind the market that although NZ growth indicators are sound the economy is failing to produce inflation. If the RBNZ remains committed, as it appears, to trying to soon return CPI inflation to target (2%), it will have little choice but to keep cutting the OCR. Our core view remains for the RBNZ to cut in November and February, taking the OCR to a cyclical trough of 1.50%.

At the long-end of the curve, NZGBs outperformed swap yesterday.

The yield on NZGB 2027s to 2037s closed down 7 bps. We believe that fundamentals continue to support demand for NZGBs. Now the dust is settling after the recent NZGB 2037 syndication, we believe swap-bond spreads can widen further i.e. NZGBs can outperform swap.

Overnight, German yields traded with a downward bias. A weak July German industrial production number may have contributed. German 10-year yields sit at -0.12% this morning. US 10-year yields have traded a reasonably tight range to trade at 1.53% at present.

Tonight’s focus will be the ECB’s meeting. After last week’s solid PMI readings the ECB may feel less minded to add further easing at this meeting. However, it will remain at pains to assure the market it is committed to achieving its inflation objective, after last week’s low-side August CPI prints. It is difficult to see German 10-year yields bursting sustainably into positive territory any time soon. Low yields outside of the US will limit the potential rise in US 10-year yields even if the Fed were to hike by year-end (our core view is for a 25bps hike in December). Equally, this will limit the rise in NZ long-end yields.

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