Roger J Kerr sees a market opportunity that should not be missed by borrowers with a high level of swap maturities over the next 12 to 24 months

 By Roger J Kerr

The upward slope (degree of incline from two to 10 year interest rates) of the interest rate yield curve has flattened over recent weeks as 10 year swap rates have reduced to 4.92% with the pullback in US Treasury Bond yields to below 2.6%, whereas the 2-year swap rates have remained elevated at the 4% level.

The 92 basis point gap between the two and 10 year swap rates has decreased sharply from the 141 basis point 2/10 year differential at the start of 2014 (5.25% less 3.84%).

In normal circumstances a flattening of the yield curve in this manner would signal that there was a lower probability of overall interest rates rising in the future.

A steep upward sloping yield curve as we had at the start of January signifies that the markets expect all interest rates to increase.

The yield curve theory does not always hold in the New Zealand context as the 90-day to 2-year interest rates are determined by NZ specific factors such as inflation, monetary policy settings and the NZD exchange rate.

The 10-year swap rates are almost solely determined by the direction of US 10-year Treasury Bond yields.

I do not expect the flatter swap yield curve to last too long for the following reasons:

- The rally down in US Treasury Bond yields to 2.58% over recent days appears very temporary in that there was a flight to quality by global investors to the safety and security of US bonds when the Ukrainian crisis escalated late last week. Like previous Ukrainian concerns the investment markets seem to move on rather quickly when things settle.

- US employment growth for the month of April at +288,000 was much stronger than prior forecasts and previous months were revised upwards. Normally, the markets would sell bonds (yields higher) on such a strong US jobs number and my view is that the selling will eventuate over coming weeks. A return to US 10-year interest rates to 3.00% appears very likely, which will lift our 10-year swap rates by 0.40% to 5.30%.

- The direction of our 2-year swap rates over coming weeks is likely to be stable at 4.00% or even marginally lower if the NZD/USD exchange rate stays well above 0.8600 and the RBNZ are forced to re-think inflation forecasts (i.e. revise downwards) and OCR increases in the MPS on 12 June.

The current flatter yield curve provides the opportunity for corporate borrowers to enter forward starting fixed rate swaps at a much lower premium added on to the five to 10 year swap rates to what prevailed a few month back.

A nine year swap starting in 12 months’ time is almost back to 5% today after being at 5.5% in January.

The market opportunity should not be missed by borrowers with a high level of swap maturities over the next 12 to 24 months.  

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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