Risk-off moves overnight. US 10-year hits 1.25%, S&P500 falls 1%. AUD prints fresh YTD low, NZD drops to 0.6940. Big fall in long-term NZ government bond yields

It has been a risk-off trading session overnight with equities falling sharply and the US 10-year rate hitting a 4½ month low of 1.25%, although both have recovered somewhat over the past few hours.  There haven’t been any major catalysts although commentators are blaming the moves on concerns around a slowdown in growth and the rising spread of the delta variant. Safe haven currencies have appreciated while commodity currencies have slumped.  The AUD has made a fresh low for the year while the NZD has dropped to 0.6940, nearing support levels.  Yesterday saw a big fall in long-term NZ rates.

Investor sentiment has grown more cautious over the past 24 hours.  One of the concerns is around the rapid spread of the Covid-19 delta variant which some see as possibly slowing down the reopening process for the global economy.   Japan announced a state of emergency, presumably reluctantly as it will likely mean spectators will be banned from the Tokyo Olympics.  Infection rates have even increased in countries with high vaccination rates, such as Israel and the UK, which have eased Covid-related restrictions.  So far, hospitalisation numbers in places like the UK and Israel remain relatively low, even with infections rising, so markets hope that more restrictive measures will not be required.

Some commentators also mention the potential for a slowdown in economic growth, with reports that China could cut its reserve requirements (RRR) seen as validating these concerns.  In the US, the likes of the ISM surveys have come off their highs, although they remain extremely strong in historical terms.  Of course, US growth simply has to slow after what is expected to be close to a double-digit annualised growth rate in Q2, fuelled by economic reopening and fiscal stimulus.  As is often the case, markets have a habit of changing the narrative to fit a story to market movements.

Equity markets are down across the board overnight.  Following big losses in Asia and Europe (Hang Seng -2.9%, EuroStoxx 600 -1.7%), US equity markets opened sharply lower overnight, with the S&P500 falling as much as 1.6% shortly after the open.  The S&P500 has recovered some ground over the past few hours although it is still down 1% on the session, albeit from what was a record high.  ‘Reflation trade’ sectors, including banks and commodity producers, have underperformed while tech stocks have held up relatively better (NASDAQ -0.7%), supported by falls in long-term bond yields.

The US 10-year rate fell to as low as 1.25% overnight, a 4½ month low and some 50bps off its late March highs.  It has recovered somewhat over the past few hours, in line with the recovery in equity markets, although it is still trading below 1.30%.  Technical factors appear to be contributing to the falls in bond yields, including short covering amongst speculative investors and anecdotal reports of buying from Japan (with Treasuries looking more attractive than Japanese bonds when hedged for FX risk) and pension funds (which have seen their funded status improve, due to the rally in equities and increase in rates).  It’s also not unusual for long-term rates to experience pullback after a big move, like that seen earlier in the year, especially when US rate hikes still appear some time away off.  We still think this is mainly a short-term indigestion issue and ultimately long-term rates, which remain extremely low on a historical basis, will eventually head higher, both offshore and in NZ.

Currency movements have largely reflected the risk-off tone.  There have been big gains for the safe haven JPY and Swiss franc overnight (+0.8% and +1.1% respectively) and heavy losses for commodity currencies.  Unusually for a risk-off episode, the USD indexes are down slightly, by between 0.1% and 0.2%.

The AUD has printed a fresh year-to-date low and is trading this morning around 0.7425.  The NZD has been the worst performer in the G10, off more than 1% in the past 24 hours to around 0.6940.  Key support levels, around the 0.6930 mark, are now in close reach.  The NZD/AUD cross has been relatively stable (-0.3% to 0.9350) but there have been big moves on some of the other key crosses (NZD/JPY -1.8%, NZD/EUR -1.5%).

As foreshadowed by media reports earlier in the week, the ECB formally announced a change to its inflation target from “below, but close to, 2%” to a symmetric 2% target.  The move brings the ECB into line with what is seen as best practice for inflation targeting.  President Lagarde was clear the ECB was not moving to an ‘average inflation targeting’ framework, like the Fed recent adopted.  Interestingly, the ECB said it planned to incorporate owner-occupied housing into its inflation assessment (like the US has with owners-equivalent rent).  In the context of fast rising house prices in Europe, this might be one way to make it easier for the ECB to meet an inflation target which it has missed for the best part of a decade.  There was little market reaction to the announcement.

Separately, the ECB also announced a climate change plan.  The ECB indicated it would eventually tilt QE bond purchases away from carbon-heavy companies and those which don’t have credible carbon reduction plans.  It also said it would take these factors into account under its wider market operations (i.e. the terms under which it accepts collateral from banks when it lends cash).  The RBNZ recently said it is evaluating whether to change its own collateral framework, to take account the likes of climate change risks.

There was another chunky fall in domestic rates yesterday, reflecting global moves and strong demand for NZ government bonds.  The 10-year bond yield fell 9bps, to 1.68%, taking its decline on the week to 15bps.  The $500m tender of government bonds met with very strong demand, with all three bonds clearing some 3-4bps through pre-tender mids and bid-to-cover ratios all in excess of 3x.  The increase to bond supply in July has been brushed off by the market so far, even with the RBNZ buying just $200m of bonds this week.  Long-end swap spreads widened by as much as 6bps (i.e. government bond yields fell by as much as 6bps more than swap rates), which is a very large move.

The RBNZ will announce its bond buying plans for next week at 2pm and given the strength of demand at present it will be either kept as it is, at $200m, or possibly reduced a bit further.  Ultimately, with BNZ economists (and the market) forecasting a November OCR hike by the RBNZ, the days of QE are numbered.  We think the Monetary Policy Committee is likely to announce a formal end date to purchases at the August MPS or even possibly at the Monetary Policy Report next week.  The fact that the market has shown little reaction to the increase in bond supply in July is an encouraging sign that the end of QE shouldn’t lead to major price adjustments, although we would still expect some upward impact on longer-term yields, all else equal.  The key drivers of NZ rates will remain the OCR outlook and movements in global interest rates.

Chinese CPI and PPI, UK GDP and the Canadian employment report are released in the session ahead.  The market is looking for strong rebound in Canadian jobs growth (+175k) and a 0.4% decline in the unemployment rate, to 7.8%.  The Bank of Canada is expected to be one of the earlier movers in raising its cash rate, albeit likely behind the RBNZ.