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Interest rate markets remain complacent over inflation outlook

Interest rate markets remain complacent over inflation outlook

By Roger J Kerr

Three year fixed-rate money (three-year swap rates) at 3.80% looks startlingly and artificially cheap against this scenario of stronger growth and an annual inflation rate above 3.00%

This statement was my final comment in this column two weeks ago and despite generally stronger NZ economic data since and a more upbeat RBNZ assessment of the economic outlook last week, the interest rate market today prices three year swaps at a whole two basis points higher at 3.82%.

In my view the markets remain as complacent as the RBNZ on the NZ growth and inflation outlook.

Despite the RBNZ signalling a likely earlier and faster increase in the OCR, the term interest rate markets are seemingly reluctant to reflect the higher inflation risk going forward. The lack of response by the markets has perhaps more to do with corporate borrowers having fixed all they want to fix and the banks having very weak demand from their home mortgage borrowers to fix their interest rates.

For three year interest rates to move up it does require a higher volume of 'fixed-rate payers' (borrowers) active in the wholesale swap market than 'fixed rate receivers' (investors).

It seems that swap rates will not shift upwards until the banks need to off-lay the risk associated with their home mortgage borrowers fixing. It seems that the housing market recovery and maybe household perceptions about the economy/interest rates have not yet got to the point where the case for fixing the mortgage is compelling.

However, I expect this point to be reached over coming months.

It may take stronger residential property market activity levels and positive credit growth numbers to convince households, the interest rate markets and the RBNZ that current interest rate levels are too low. 

Whatever way you look at it, the time is getting closer to when three-year swap rates reverse sharply upwards.

One would have to be very pessimistic on the outlook for the NZ economy not to agree with a forecast of three-year swap rates being 0.50% higher in six months and 1.00% higher in 12 months time.

Stronger than expected consumer confidence indices and retail sales (Q1) numbers this week may start to jolt the interest rate markets out of their complacent slumber.

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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. This column was written before the Monday quake. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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