By Roger J Kerr
There are two possible scenarios for our interest rate markets over the next 12 months in terms of rate direction and yield curve shape.
1. Global recession 'doomsday' scenario:
- Plunging global growth and commodity prices suggest future deflation risks, not inflation risks.
- Economic carnage in Europe and the US causes a major slowdown in China. The European Central Bank is forced to cut their interest rates. US 10-year Treasury Bonds stay below 2%.
- While the NZ dollar would follow our commodity prices lower (the automatic shock absorber of the floating currency doing its job), incomes in the productive export sector still reduce. Investor, business and consumer confidence within New Zealand falls - despite the AB’s winning the Rugby World Cup.
- The RBNZ keep the OCR at 2.5% for a sustained period, however the yield curve may steepen as foreign investors sell out of periphery bond markets like New Zealand and thus force longer-dated yields higher.
- Borrowing costs do not necessarily reduce and may increase as bank funding margins in disrupted global debt markets increase sharply. Local banks fund their requirements locally with domestic market bond issues.
- Much lower GDP growth than forecast in New Zealand (thus lower tax revenues coming in) forces the Treasury to revise upwards the fiscal/budget deficit forecasts over coming years. Standard & Poor’s more likely than not to downgrade NZ’s credit rating under this scenario and thus another reason for borrowing margins to increase.
2. 'Muddle-grind through' scenario:
- A global double-dip recession is avoided and there are no major bank failures in Europe. Investment and financial markets stabilise and settle in for the long slow grind to economic recovery.
- The Europeans do manage to contain the fallout from a Greek debt default and investor confidence slowly returns.
- The US Congressional Joint Committee mandated to find the fiscal policy and debt answers come up with a credible plan by 23 November. Again, investor confidence restored and the US economy slowly recovers.
- The Obama administration finally recognise the major blockage in the US economy is the residential real estate market and come up with a rescue-bailout package for those underwater with negative equity.
- Commodity prices stabilise and the Chinese keep their domestic economy humming along.
- The NZD/USD falls far enough for export industries to hedge forward to protect profits and they start to invest/expand again. New Zealand GDP growth recovers up to the +3% area in 2012 and the RBNZ have the room to return short-term interest rates to “normal” levels of around 4%.
- Credit spreads in international debt markets slowly come down, eventually lowering bank borrowing margins.
- Long-term bond yields go no lower than current level and eventually move up on the prospect of global growth and moderate inflation increases in the long-run.
What I think
My best guess of the probability weightings of these scenarios eventuating into fact?
Scenario 1 = 25%
Scenario 2 = 75%
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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
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