By Roger J Kerr
One challenging aspect for local corporate borrowers managing interest rate risk over multiple years is the interaction between two almost separate and independent interest rate markets.
Short-term interest rates out to two years are determined by local inflation, RBNZ monetary policy settings, NZ house prices, NZ GDP growth and the NZD exchange rate level.
However, our interest rates from two to 10 years are determined by US Treasury bond yields which are driven by global investor sentiment, US inflation, USD GDP growth and where the big US pension funds see their long-term interest rates heading in the future.
What has happened in recent months is that the NZ two-year swap rates have increased to 4.00% and our 10-year swap rates have decreased from 5.25% to 4.75% (driven by the unexpected 0.50% reduction in US 10-year Treasury Bond yields).
The 2/10 year differential has decreased from 1.50% in December to the current 0.75%.
In my view, such a low differential (flat yield curve) is just not sustainable in the medium to longer term.
Under the scenario of US bond yields increasing by up to 1.5% over the next 12 to 18 months, the 2/10 year gap could blow out again to well above 1.50%.
Therefore, all borrowers with fixed rate swaps maturing over the next two years must be taking advantage of the flat yield curve today and entering forward start swaps to mitigate their market interest rate risk and extend the duration of their interest rate hedging.
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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
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