- Central banks are focussed on bringing down inflation
- The Reserve Bank of New Zealand amongst the earliest to hike rates and now others are moving rapidly
- Sharp interest rate rises are now largely baked into financial markets
- Lowering inflation is the best outcome for businesses and ultimately households
- We think expectations of a cash rate of 4.6% by May 2023, is excessive although markets will continue to monitor inflation closely
Through the course of 2022, inflation across the world has continued to increase, and has been challenging a prior expectation amongst many central banks that this phenomenon would be transitory. The consequences of the Ukraine war, tight labour markets, ongoing supply chain issues and policy-stimulated consumer demand have all operated in sync. Central banks, after a phase of reticence, are concerned that the rise in core measures of inflation could filter through to higher long-term inflation expectations.
Choking off excessive demand now, and normalising monetary conditions, is likely to involve less pain than allowing inflation to rise further.
To the credit of the Reserve Bank of New Zealand (RBNZ), they were one of the earlier banks to recognise the danger of rising inflation expectations and started hiking the Official Cash Rate (OCR) last October. They now have the OCR at 2.0%, which is broadly at a level that they consider neutral. However neutral rates may not bring inflation back inside a 1% to 3% target range within an acceptable timeframe. Consequently, in their May Monetary Policy Statement the RBNZ projected that the OCR would need to rise to 3.8% by mid-2023, as they take a ‘resolute’ approach towards managing inflation expectations.
This week the US Federal Reserve hiked the Fed Funds Rate by 0.75% to 1.5% - 1.75% (the Fed sets a range for Fed Funds) as US inflation has continued to rise, with the latest data showing consumer prices rising by 8.6%. The path of US interest rates is a crucial factor influencing longer term global bond markets and as an anchor for equity valuations.
Markets globally are anticipating interest rate hikes across all major economies other than in Japan and China. In New Zealand, the local bond market market priced in rate hikes earlier than elsewhere, which might imply more stability in New Zealand as other markets played catch up. However the New Zealand market continues to march interest rate expectations higher and, despite some pull back in recent trading sessions, the OCR is expected to reaching over 4.5% in May 2023. This is nearly 1% above the level the RBNZ projects. We think that the market is pessimistic in this projection.
Already households are feeling the brunt of the higher cost of living and also mortgages being refixed at higher interest rates. Consumer confidence is very weak and the housing market is slowing fairly quickly. In New Zealand and elsewhere, recession fears have grown.
For the Reserve Bank, a slower economy is exactly what is needed to diminish inflation pressure. With the labour market still very tight, the slowdown needs to be more than inconsequential. However no central bank wishes to crush their economy. Indeed, the Reserve Bank’s Policy Target Agreement includes an operational objective of avoiding “unnecessary instability in output, interest rates, and the exchange rate”[1]. At present, with markets pricing an OCR around 4.5%, that implies term mortgage rates well in excess of 6%. The economic risks seem skewed towards a sharp slowdown in New Zealand, perhaps one that is beyond the RBNZ’s appetite and mandate.
Consequently, we think market pricing has gone too far at present. At present, with inflation credibility at front of mind, the Reserve Bank is probably going to continue to emphasise their determination to subdue inflation pressures and signal rate hikes. However, as the year progresses and more hikes have occurred, we will be in an environment where monetary conditions have become tight and the economy is more clearly slowing. At this stage, communication can change and the Reserve Bank can slow down the hiking path and watch to see whether further hikes will be necessary.
In this scenario, bond markets can become more stable and eventually the valuation link to equity markets may see this first pillar put in place for valuations to stabilise across most asset classes.
With so many rate hikes currently priced in, we would need an even worse inflationary outlook to trigger a meaningful further rise in bond yields.
Supporting this argument is that longer term bond yields now reflect an ongoing environment of inflation sitting around the top of the Reserve Bank’s target range. At 4.25%, the New Zealand 10 year Government Stock yield points to continuing tight monetary policy as well as a term premium to compensate investors for some inflation uncertainty (for more, see The end of the “Great Moderation?” published last week). At around 5%, the running yield on Harbour’s New Zealand bond funds is also significantly higher than in recent years.
At some point we anticipate investors will cease looking in the rear vision mirror at one of these worst on record periods for fixed interest returns, and instead look forward. The positive impact of central banks getting serious about inflation is that savers tend to have greater confidence in the real returns they receive across all asset classes.
[1] Reserve Bank of New Zealand (Replacement of Remit for Monetary Policy Committee) Order 2021
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