By Roger J Kerr
Short-term 90-day wholesale interest rates set to stay below 3.0% for another 12 months provided the NZ dollar currency does not completely tank and depreciate.
Significant NZD currency falls appear highly unlikely judging by recent offshore demand for a safe and secure currency that has an economy with GDP growth rate of +3%.
With the NZDS/USD exchange rate likely to sit in and around 0.8000 over the next 12 months as the highest probability scenario, it is a particularly difficult decision for any major borrower to fix interest costs via swaps at 3.68% for a 10 year term.
The pain of the payments away under the swap contract (difference between 3.68% and the 90-day wholesale BKBM rate) for the first 12 months dissuades many from making that decision.
However, those borrowers who can see past the currently popular Kiwi dollar, the real risk is not NZD/USD or 90-day bank bill interest rate movements. The real risk is whether US 10-year Treasury Bond yields move lower, stay where they are at 1.63% or move higher.
Our three to ten year swap rates are totally driven by US Treasury Bond interest rate changes, provided you make the assumption that the NZ bond to swap spread stays at 25 basis points and the US:NZ Government Bond spread remains at 180 basis points.
Add the three components together and you get NZ 10-year fixed rate swaps at 3.68% (1.63% + 0.25% + 1.80%).
The US Treasury Bond yield at 1.63% has the biggest propensity to change over the next 12 months.
My view is that the 1.63% base rate is far more likely to increase than decrease; therefore corporate borrowers should not be afraid to take a 10-year view and pay away the gap over the next 12 months.
If the borrower waits for a year before fixing, to be sure NZ 90-day rates are rising, the US Treasury Bond yields may well be 1% higher at that time, thus the 10-year swap rate here will be 4.68% (an even tougher decision to make!)
Reasons why US bond yields are more like to increase from 1.63%, than decrease are based around:
- Relative to equity prices, bonds are very expensive at 1.63%. Investors in US Government bonds are more likely to be sellers than buying more bonds as they allocate and re-weight in favour of investment asset classes with more upside.
- Whichever way you look at it the US fiscal cliff in early 2013 is negative for bonds. US budget deficits remain very large and new issuance bond supply remains at record highs.
- Renewed monetary stimulus around the globe lowers the probability of a global double-dip recession. Eventually GDP growth will return with associated inflation risks. A return of 1.63% is already below the US annual inflation rate and producing negative real returns.
- US corporate borrowers with more confidence the economy will now recover with QE3 operating are more likely to fix increased volumes of debt.
- The buying of US Treasury bonds as a safe haven away from European risks has reduced as the risk in Europe have decreased with banking market, fiscal and monetary policy reform progress.
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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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