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Interest Rates Race to Zero?

Harbour sails 8
Harbour Team | Posted on Jun 24, 2019

Yields on fixed interest securities, which have been falling sharply all year, took another surge lower last week. The 5-year swap rate, a good proxy for market rates in New Zealand reached 1.36%, down from 2.20% at Christmas 2018 and 2.65% a year ago. That’s a record low level for NZ bond yields. The primary catalyst last week was a signal that the US Federal Reserve is close to cutting rates. They are joining the central banks in New Zealand, Australia and parts of Europe in shifting to a decidedly dovish stance over recent weeks.

  • Most activity indicators point to deteriorating economic momentum, but with monetary conditions easing, a recession seems unlikely.
  • Market prices are anticipating quite aggressive rates cuts and some commentators are extrapolating the trend, looking for rates to head towards zero. We have a more benign view for New Zealand.
  • Lower term deposit rates and lower mortgage rates could be around for some time.

As rates have dropped, some commentators have even suggested that rates in New Zealand and the US could join Europe and Japan, where long-term government bond yields are trading below zero percent. This is a striking call, given the generally decent shape of the New Zealand and US economies. In NZ with GDP growth at 2.5%, the unemployment rate at a low level of 4.2%, and our terms of trade and fiscal positions both in a good space, a casual observer could quite rightly be scratching their head. Why on earth would interest rates be falling so sharply?

Of course, there are some negative factors at play in the domestic and global economy as well. Most notably this year, the ongoing trade disputes and geopolitical tensions have looked less and less likely to be resolved soon. Nervousness over large tariffs has hit business confidence and trade globally.  This has introduced some weakness in the economic cycle, which is already long in the tooth and without any clear drivers to provide fresh growth. When one adds the longer-term structural pressures that come from high debt levels, ageing populations and the probable cost of climate change, the short-to-medium term growth outlook is fairly soft. A recession seems unlikely and certainly isn't expected by equity market participants.

Softer economic conditions are reinforcing a sense of subdued inflation at present. Low inflation expectations are crucial for how central banks are approaching monetary policy. In most developed countries inflation is a little below target. The deterioration in the growth outlook now makes the task of lifting inflation towards targets look harder. Given that nearly all major central banks are inflation targeters, softness in growth and reduced inflation pressures almost mechanically trigger rate cuts. Accordingly, central banks have started to react in a way that is totally consistent with their mandates.

However, market prices are anticipating quite aggressive rate cuts. Currently, cuts of 0.5%, 0.6% and 1.0% are priced into the New Zealand, Australian and US markets. In New Zealand, that would see our Official Cash Rate (OCR) drop to 1.0%.

Source: Bloomberg

How likely is this, and could rates go even lower than 1%? Certainly, at present, most activity indicators point to deteriorating momentum but not a recession.

In our judgement, the relatively quick shift in tone from central banks suggests we are likely to get rate cuts in the near term. The Reserve Bank of New Zealand has already started, cutting the OCR in May. The sooner and more assertively that the central banks move, the more likely that we see a recovery in confidence and a rise in economic activity. Ultimately, if confidence recovers, fewer cuts may be needed. As the old adage goes, a stitch in time saves nine! In New Zealand, we have already seen monetary conditions ease over recent months, with the NZ dollar and mortgage rates lower. Given the traditional lags between changes in monetary conditions and economic activity, we believe that the existing easing in monetary conditions may already have seeded a recovery in confidence.

Of course, other events could overwhelm the scope for easier monetary policy to stimulate a recovery. It could be that further interest rate cuts might just be like pushing on a string if firms and households are unwilling to borrow for investment or consumption. Trade wars and geopolitical tensions may continue to impact and wash through into softer economic activity. In New Zealand, the threat of tighter bank lending standards looms, as the Reserve Bank contemplates higher capital requirements for the banks.

This week, the Reserve Bank reviews the Official Cash Rate.

While they may choose to keep the OCR at 1.5% this time, expect a clear signal that more cuts can be provided if economic conditions moderate further while in the US it is clear that the Federal Reserve would prefer to err on the side of "running the economy hot". What this means is that we should expect lower term deposit rates and lower mortgage rates for some time.


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