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Bond yields hit record lows; but a rate cut is not a done deal

Harbour sails 5
Mark Brown | Posted on Apr 1, 2019

New Zealand government stock yields fell to record low levels across all maturities last week, as the Reserve Bank acknowledged the weaker global economic outlook and the ensuing risks to the domestic economy. We think:

  • The economy has slowed but is still growing.
  • Bond yields appear to be pricing in a recession, which seems unlikely.
  • Rate cuts in New Zealand are not a done deal.

The decline in yields has been dramatic this year, with the benchmark 10-year yield falling by 0.6% to 1.75%. On the back of the Reserve Bank’s comment that “the more likely direction of our next OCR move is down”, the market has priced in an OCR rate of 1.3% in February 2020, down from 1.75% at present.

 Navigator april 2019 v2

While the phrase “more likely” may only reflect a skew in a range of outcomes, the decision to include this language is not taken lightly. Indeed, Governor Orr has expressed satisfaction that the market has moved to price in cuts and taken the NZD lower.

The economy has slowed over recent quarters to a growth rate of 2.3%, but other data are quite satisfactory. The labour market is judged to be near its maximum sustainable rate and core CPI has been climbing towards 2%. We are nowhere near the recessionary conditions one might expect to see when bonds yields are hitting record lows.

So, what has been driving the move lower in yields and why are market participants pricing OCR cuts? We can identify a range of contributing factors:

  • Global growth has been declining for over 6 months, partly in reaction to the gradual removal of the post-GFC extraordinary stimulus that was in place over the last decade;
  • Solid NZ employment and CPI data are generally viewed as backward-looking, while forward-looking indicators, such as business confidence are weaker;
  • There is concern that the Reserve Bank’s proposed bank capital policy will tighten lending conditions in New Zealand;
  • The government’s excellent fiscal position and ongoing surpluses have meant the supply of bonds has not satisfied demand from a growing market, so investors have chased bond yields lower;
  • Domestic fund managers have also been buying long-dated bonds as the duration of market benchmarks have lengthened considerably;
  • The Reserve Bank may be judging that, under the new Policy Target Agreement, which aims for both price stability and maximum sustainable employment, a lower OCR might support the jobs market without running excessive inflation risks. The Governor has made this argument over recent months.

So, what do we make of all this? Firstly, it is hard to argue about the direction the market has taken. Nearly all of the news flow has been negative. Where we are less convinced is with regards to the magnitude of the rally, some of which relates to the likelihood of rate cuts, both in New Zealand and offshore.

In New Zealand, monetary policy is already very accommodative and has been a factor behind the strong labour market and rising inflation. Core inflation is gradually rising, and firms look likely to face ongoing cost pressures, particularly for wages, where skills shortages and increases in the minimum wage are continuing. With our terms of trade at a healthy level, with the government planning to increase spending, and with initiatives such as the NZ-China Year of Tourism, the forward news flow will not all be unsettling. The financial markets are pretty close to treating rate cuts as a done deal, but we would not go further than the RBNZ’s line that “the more likely direction … is down.”

Pricing at the longer end of the yield curve for 10-year and longer bonds is also expensive in our opinion. The 10-year swap rate, at 2.15%, is roughly pricing an OCR rate of 1.25% over the next 5 years and 2% over the subsequent 5 years. That is well below the Reserve Bank’s estimated neutral cash rate, of 3.5%, even allowing for a drift lower over time.

Putting it all together, we have a news flow that has taken yields to record low levels. Valuations are undeniably expensive. Whether this is sustained or not will be determined by economic data over the coming months, as this will drive central bank policy decisions and the willingness of investors to keep putting money into low-yielding bonds.



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