By Roger J Kerr
One-way interest rate markets where prices can suddenly gap to another level entirely are the type of financial risks that borrowers and investors need to have robust risk management policies and hedging limits in place for.
The spiral upwards in US Government Treasury Bond yields from 1.60% to 2.75% over recent weeks is a prime example of such a market shock or risk event.
The signalling from the Federal Reserve that they will phase down their bond buying coupled with stronger than expected US jobs numbers last Friday have combined to spook the US bond market into a panic sell.
Our long-term interest rates from three years onwards are totally driven by US bond yield movements.
The high correlation between the two markets being due to the high 70% foreign ownership level of NZ Government bonds on issue.
When Asian sovereign wealth funds sell US bonds to reduce their portfolio duration they simultaneously sell the equivalent of bonds in their NZ bond portfolio. The recent value destruction in the US bond market will be causing major negative returns for fixed interest fund managers around the world and many will be abruptly selling bonds to reduce their portfolio risks. As can be seen the selling feeds on itself and a one-way market results.
Local corporate and retail borrowers who have been relying on RBNZ assurances that the OCR will not be increased this year and thus have not implemented fixing or hedging transactions have missed the boat badly as wholesale fixed term swap rates have also spiralled sharply higher on the back of the US moves.
Banks have been busy increasing fixed rate mortgage interest rates and there is a lot more to come.
With NZ 10-year swap rates already at 4.7% it is debatable whether a fixed rate swap for 10 years will be an effective hedge against where 90-day wholesale interest rates may average over coming years.
Six and seven year fixed rates between 4.2% and 4.4% may still make some sense for borrowers who have held off from fixing over recent years.
Has the US bond market overreacted and overshot in this panic market response to the Fed and strong jobs figures? The speed of the increases may suggest some pullback; however it is difficult to see who the buyers of bonds will be in this market environment.
US Treasury bond yields at 2.75% still have to be considered low against the outlook for US GDP growth, inflation and employment.
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Roger J Kerr is a partner at PwC. 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
2 Comments
The world is still a mess, there is far too much leverage and much of the developed world is still having to print money to pay the bills. The excessive leverage just has to come home to roost. I'm not yet convinced that the world is in full recovery mode and that interest rates are a one way bet. The world can not afford higher interest rates.
I understand what Roger is saying here but I think we'll see far more volitility in global bond prices over coming months and it wont all be one way. I have no doubt that there will be buying opportunities in bonds in fact we might be getting close to that point now!
One-way interest rate markets where prices can suddenly gap to another level entirely are the type of financial risks that borrowers and investors need to have robust risk management policies and hedging limits in place for.
But timing is everything when it comes to the bond trading business, that is why there are star traders retiring early with the gains, while others join the employment line for waiters. Well maybe not in crony capitalist NZ.
US T10s recorded cycle low yields of 1.39% in the 4th week of July 2012 and yet Auckland City Council's finance team, and I guess with help from outside advisors, reported losses associated with interest rate swap hedges at $167 million for the period June 30 2012. Read more
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