Entry of NZGBs into the World Bond Index pushes NZ bond yields lower and drives NZD outperformance, against a backdrop of a strong USD

The overnight trading session has been uneventful, as a turbulent month closes and ahead of a busy week loaded with event risk. Against a backdrop of a stronger USD, commodity currencies have outperformed, led by the NZD as it manages to hold its ground, supported by month-end buying with NZGBs being added to the WBGI. This also saw NZGB yields fall into month-end and wider swap spreads. US equities are closing the month on a weaker note after their recent strong rally, while global rates have pushed higher.

There is plenty of event risk on the calendar this week including central bank meetings for the US, Australia and the UK, and key US economic data on the labour market and the ISM indices. Domestically, labour market data will be important ahead of the next RBNZ meeting.  Ahead of all that, price action has been well-contained and month end flows are no doubt part of the picture.

The US S&P500 is currently down 0.6%, but even a close of that magnitude will see it up about 8% for October. Strong equity market gains for the month have come about since the market narrative turned towards a “pivot” in peak central bank hawkishness, influenced by that now famous WSJ article on the 21st of the month by Nick Timiraos, seen as a mouthpiece for the Fed when it wants to send a message to the market. 

Ahead of the key FOMC announcement Thursday morning NZ time, US Treasury yields have pushed higher, with the 2-year rate up 7bps to 4.48% and the 10-year rate up 4bps to 4.05%. Even though another 75bps is well priced, there are plenty of nerves about how Chair Powell will frame the policy outlook, trying to navigate a stepdown in its future rate hikes, as projected in September, but without over-exciting the market about a pivot to avoid a major easing in financial conditions.

In economic news, US regional manufacturing PMIs continued to undershoot expectations, with the Chicago PMI and Dallas Fed manufacturing index adding to that trend overnight. The key ISM manufacturing index due tonight is expected to slip further to 50, with some chance of breaking below that mark which would signal a contracting manufacturing sector.

As forewarned by Friday’s regional data, euro area CPI inflation surged to 10.7% y/y, still higher than the upwardly revised consensus estimate of 10.3%. Core inflation was 5.0% y/y. Th euro area economy managed to skirt recession, with GDP up 0.2% q/q in in Q3, but recession still looks unavoidable as winter begins, in the face of the energy crisis and as the ECB continues to tighten policy. The only question is whether the ECB dials down rate hikes from 75bps to 50bps in December, or the still-strong inflationary backdrop encourages a third consecutive 75bps hike. The market is priced roughly halfway between the two options, but some on the governing council argue for smaller steps against the growing chance of recession.

In currency markets, the backdrop is one of a stronger USD, with European currencies leading the fall. GBP is 1.3% weaker at 1.1460, unwinding some recent strength, but it will still end up one of the better performing currencies for October, on a reduced political risk premium under the new PM and Chancellor. EUR is down 0.8% to 0.9880.

Japan MoF data showed that it spent a record USD42b in the four weeks to 27 October, a step up from the USD19b September spent in late September in the first round of intervention. The aggregate USD61b spent has slowed the pace of yen depreciation, but more will need to be spent to prevent further depreciation against a backdrop of the BoJ’s ultra-easy policy stance and rising rates elsewhere. USD/JPY is up 0.7% to 148.60.

Over the day, the commodity currencies have outperformed, with the AUD and CAD showing only modest falls against the strong USD and the NZD managing to hold its ground, hovering just over 0.58. Month-end flows will be part of the story, with the NZD getting an added kicker as NZGBs enter the FTSE-Russell World Government Bond Index. This sees the NZD higher on all the key crosses, with NZD/AUD approaching 0.91.  While one can point to month-end support, the NZD has been well supported through October overall following wider NZ-global rate spreads after the more hawkish RBNZ update earlier in October, and some recovery from an oversold level being two key driving forces.

Of note the NZD and, to a lesser extent the AUD, show signs of de-coupling from the weaker yuan, with USD/CNY moving back over 7.30 on USD strength and China’s self-inflicted economic malaise. China PMI data were weaker than consensus estimates and consistent with the sluggish economic momentum picture, as you’d expect under the zero-COVID policy that is depressing confidence and inhibiting activity. China’s COVID19 cases released yesterday showed a further rise to 2675, the highest in nearly two months, with the virus spreading rapidly in two-thirds of provinces. As well as causing local economic disruption as lockdowns are invoked, there remains an impact on global supply chains, with reports of staff fleeing Apple’s key production plant in Zhengzhou to avoid lockdown requirements.

NZGBs were driven lower yesterday on big offshore flows as they enter the WGBI. Local dealers were well prepared for the onslaught of buying activity but swap spreads still widened as NZGB’s outperformed. NZGB yields were 4-8bps across the curve, led by the long end, the 10-year rate closing the day down 7bps to 4.16%. The 2-year swap rate rose 3bps to 5.02% while 10-year swap fell “only” 3bps to 4.61%. We estimate around $2b of inflows for the first month of NZGB’s inclusion in the index and around $4b over the first three months.

In the day ahead, we’ve noted the US ISM index, but the JOLTS job openings data has risen in importance and there will be interest in the figures following the big fall seen in August. Another big fall would influence Chair Powell’s tone later this week, given it is one of his favourite indicators for assessing the state of the labour market. Later this afternoon, the RBA is widely expected to hike by 25bps to 2.85%, but there is an outside chance of a 40bps or 50bps increase, following the shocking CPI data last week. A speech by Governor Lowe tonight will provide more colour around the policy decision.