Opinion: Flatter yield curve by no means guaranteed

By Roger J Kerr

The New Zealand interest rate yield curve is going to get steeper in slope over coming months (long term rates up, short-term rates stable) before we see any other change to its shape.

The more steeply sloping curve will come from higher US Treasury Bond yields pulling up NZ long term bond and swap yields.

The historical correlation between NZ and US long term interest rates is very high and unlikely to fundamentally breakdown anytime soon.

It is however fair to say that recent increases in US 10-year T/Bond yields from 3.00% to 3.64% have not been matched by 64 basis point increases in NZ 10-year bond and swap rates.

One reason for this temporary breakdown in correlation is the strong demand for new issue NZ Government bonds (at the weekly tenders) from Middle Eastern and Asian investors - that is, sovereign wealth funds.

These investors have been seeking to diversify some of their bond fund weightings away from US and European bonds to smaller markets like ours.

Another factor causing the somewhat surprising rally downwards in NZ 10-year swaps rates from 5.50% to 5.35%, over a period where US bond yields have increased, has been the unwinding of speculative yield curve spread trades. Offshore investment banks previously held open curve trade positions anticipating the yield curve to steepen - that is, they bought the short-end, sold the long-end.

To unwind or close-down these market positions they have been forced to buy the 10-year swaps – forcing the yields lower in always thin markets.

I do not expect the drift lower in our 10 year swap rates to continue, despite the further delays in when the RBNZ will increases the OCR this year.

If global bond investors are shortening the duration of their portfolios because US long-term bond yields are rising and positioned to rise a lot further, it is hard to see them buying our long term bonds or being investors in our 10-year swaps. There is little current demand on the pay side of the long-term swaps market as corporate borrowers are already highly fixed and set, or those that are not highly fixed do not see fixing rates at 5.50% as an economic hedge against a likely future “monetary policy neutral” 5.00% OCR/90-day BKBM.

However, I do expect our 10-year swap rates to reverse back up and catch up to the increase in the US long term rates.

The investment world has moved from expectations of deflation to rising inflation in the space of the last six months.

I never bought into the deflation maxim because Asia bounced back very quickly from the GFC and the US economy was always going to respond to massive monetary stimulation at some point. The US economic data coming out continues to improve and the latest lift in US bond yields to 3.64% reflects the bond market pricing- in higher future growth and higher future inflation.

Those corporate borrowers waiting for the yield curve to flatten by short-term swap rates (one to three years) increasing on OCR increases, to generate lower forward-start swap rates to extend existing swaps, have to recognise the risk that the lower forward start swap rates may not eventuate at all if the long-term yields continue to increase - that is, a parallel shift higher in the yield curve over the remainder of the year.

The gap between two-year and 10-year swap rates is currently 1.55% (3.80% against 5.35%). Do not rule out a parallel shift up over the next 12 months with both two and 10 year rates being 1.00% higher and the gap the same at 1.55%.

Corporate borrowers with increasing or new debt levels who need to fix long-term to meet hedging policy limits, should perhaps avoid 10-year swap rates above 5.50% and look to fix a greater percentage in the five and seven year maturity region at 4.65% to 5.00% swap rates.

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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