Opinion: RBNZ finally realise they need to catch up to the market

By Roger J Kerr

The change in wording and tone in the RBNZ OCR review statement last week to a more positive outlook for the economy this year (compared to the outright dovish tone in the December MPS) indicated to me that the central bank has finally recognised it needs to rectify the jam they have created for themselves.

By leaving official interest rates 2.00% below true market interest rates over the last 18 months, the RBNZ have painted themselves into a corner in terms of monetary policy flexibility and effectiveness.

They now run the real risk of having to catch-up rapidly in the second half of 2011, increasing official rates in big steps from 3.00% to 5.00% to just catch-up to current market rates. 

All this will do is potentially pushing the exchange rate up.

Domestic economic activity in terms of the behavioural decisions of investors, borrowers and consumers will not change as market interest rates will not change too much (they are already at 5.00% i.e. the banks’ cost of funds).

The more upbeat outlook from Governor Alan Bollard and his economic gurus is correct in my view.

The RBNZ realise that they now have to condition the moneymarkets and public expectations that the emergency low rates are no longer appropriate and increases in official rates are coming.

The strategy is to get some increases in the two and three year market swap rates ahead of time so that they can point to higher market levels when they increase official interest rates later on.

Of course they have left this action far too late, allowing the OCR to be 2.00% below the actual market price of money for so long was always going to cause them a problem at some point. That time has now arrived and they will need some smart manoeuvring to get themselves out of this predicament. Leaving OCR increases until too late in the piece in September will cause too much collateral damage to the export sector (an economy) with the NZD being pushed up on its own.

Our economic growth forecasts for the first and second quarter of 2011 is for quarterly increases greater than 1.00% each, when the data is announced in June and September.

A rebound in agricultural and manufacturing production after the weather related reductions in the second half of 2010, coupled with improving retail/housing sectors will be behind the higher GDP growth numbers.

The RBNZ need to pre-empt these stronger figures, thus the change in tone in last week’s OCR statement which surprised the naysayers/doomsayers on the performance of the economy (typically Wellington-based economic forecasting groups). It appears the RBNZ finally understand what the record high export commodity prices do to growth in the NZ economy.

What all this means for the direction of interest rates and the slope of the yield curve this year is that the three to 10 year swap rates will be moving progressively higher over coming months as the markets price-in the RBNZ changes and the US bond yields continue to increase.

Those borrowers not fixed to high percentages should concentrate new fixings in the two to four year part of the interest rate yield curve.

Fixed interest investors can still expect higher market base rates later, however the corporate credit spreads (margins) will be lower as the shortage of new-issue bonds cause demand to exceed supply.

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 * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com