Bond Market Momentum, Valuation and Risks

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1 Bond Market Momentum, Valuation and Risks New Zealand Fixed Income Monthly Commentary August Global bond yields stabilised in July, as markets weighed up two opposing forces: continued economic recovery pushing yields higher, versus yield curves that are steep and already factor-in higher future cash rates. In New Zealand, the RBNZ finally acknowledged the strength of the NZ economy, opening the door to them removing monetary stimulus faster than previously flagged. The market expects around basis points of hikes by April 1. Fonterra s product safety issues create a new risk to the NZ economy. For fixed interest markets, it will depend on whether the threat to NZ s export income is material enough to effect overall growth, which in turn will be influenced by the degree to which the currency works as a shock absorber. Looking further ahead, we continue to see sufficient global and domestic economic momentum to support higher bond yields over the medium-term. Two Strong Opposing Forces... Global bond yields rose sharply over May and June, following signals from the US Federal Reserve that it was considering tapering the size of its Quantitative Easing (QE) bond purchases, as evidence grew that the US economic recovery was gaining traction. The US 1 year yield rose from a low of 1.% in early May to as high as.7% in early July, leaving yields at their highest levels since mid 11. Through the course of July, global bond yields began to stabilize, as two strong opposing forces worked against each other. Momentum: Bond investors are far more wary about investing in long-term bonds, given the upward momentum of the yields and the fact that the US Fed has signaled that it won t necessarily cap bond yields with the weight of its QE purchases. Valuation: Long-term bond yields have already risen considerably. So those bond investors willing to hold long-term securities are receiving some compensation from considerably higher yields than available from short-term securities and cash (Chart 1).

2 Chart 1. US 1 Year and Year Bond Yields US year yield US 1 year yield Difference Source: Bloomberg. Some bond maths... Whether it is appealing to invest in long-term fixed interest securities or sit on cash depends on your view on the return from holding cash through time: the longer that cash rates remain near zero, the more attractive it is to hold higher yielding long-dated securities; the faster that monetary stimulus is removed, the more reason to avoid locking in long-term. The most recent economic forecasts of the US Federal Reserve provide an insight into the expectations of the 19 members of the FOMC (Federal Open Markets Committee). It highlights that while they intend to eventually lift the overnight US Fed Funds Rate back to around %, they expect that cash rates can remain near.% for the next couple of years (Chart ). That is, whether or not they taper their QE bond purchases faster or slower, they still intend to keep cash rates anchored. Chart. FOMC Member Expectations for the US Fed Funds Rate Number of FOMC members Source: US Federal Reserve (June 1). Expectation of Fed Funds Rate End 1 End 1 End1 Longer Run

3 Using the bond maths of fixed interest markets, we can take alternative tracks for US cash rates and back-out what that implies for fair value US bond yields for different maturities. In other words, we can take a forecast time series for future US cash rates, and use this to back out what it means for the US yield curve today. Chart sets out alternative paths for the US Fed Funds rates, and how these map into alternative yield curves in Chart. The three different scenarios all lead to US 1 year rates in the range of -%. Importantly, it takes quite an aggressive path for the US Fed Funds Rate to imply that US 1 year yields should be at the top of this range at %. So while over a long-horizon US 1 year yields may eventually settle at around %, in the meantime low cash rates should keep bond yields relatively anchored. Consistent with this analysis, following a sharp rise in bond yields in May and June, the US 1 year rate settled at around.% for much of July, as investors saw appealing value as yields approached %. Chart. US Overnight Interest Rate Slow Fed Fast Fed Chart. US Yield Curve (-1 years) Slow Fed Fast Fed Faster Fed Faster Fed Years Years to Maturity 1 Source: US Federal Reserve (June 1). The RBNZ finally change their tune While the Fed surprised the market in May and June with talk of tapering QE, the RBNZ stuck stridently to its message that the Official Cash Rate (OCR) remains on hold. However, the evidence of economic momentum has been mounting in recent months: The ANZ Business Outlook has firms Own Activity Outlook at a high net % positive. The Westpac Consumer Confidence index has risen to its highest level in years. Net migration has lifted to its highest level in years. New dwelling units authorized are at their highest level in years. Auckland annual house price inflation is around 1%, its highest rate in years. Fonterra had increased it projected payout for the 1/1 season. The NZ Dollar Trade-weighted index has fallen notably from its 1 highs.

4 This more upbeat outlook is also captured in NZ s PMI, which remains elevated, well into the expansionary zone above (Chart ). Chart. NZ, US and European Purchasing Manager Indices (PMIs) Index 8 NZ PMI US PMI Europe PMI Source: Bloomberg. While the RBNZ decided to keep the Official Cash Rate (OCR) on hold at its July review, it made two material changes to its press release that recognise the strength of the economy. First, in the important final paragraph they acknowledged that the removal of monetary stimulus will likely be needed in the future. This is the first time since Graeme Wheeler s appointment that they have officially moved to a tightening bias. Previously, their statements had been more even handed, opening the door to either hikes or cuts. Second, while they expect to keep the OCR unchanged through the end of the year, they have made clear that extent of the monetary policy response will depend largely on the degree to which the growing momentum in the housing market and construction sector spills over into inflation pressures. This is what economists call making their decisions data dependent. In layman s terms, the RBNZ have sent a clear signal that they are reserving the right to put rates up sooner if economic data surprises on the upside in coming months. The market is now placing a % chance of a bp hike at the RBNZ s January 1 meeting, with the OCR expected to rise to.% by April 1. By contrast, as the Australian economy has stalled in recent months, the market is expecting the RBA to cut its official cash rate towards.% by mid 1 (Chart ).

5 Chart. NZ and Australian Cash Rates Market Expectations for 9 months Ahead.. RBNZ - 9 months ahead RBNZ OCR RBA - 9 months ahead RBA OCR.7... Jan-1 Feb-1 Mar-1 Apr-1 May-1 Jun-1 Jul-1 Aug-1 Source: Bloomberg. Fonterra s product safety issues announced at the beginning of August create a new risk to the economy. 1 For fixed interest markets, it will depend on whether the threat to NZ s export income (taking into account quantity and price impacts through a lower currency) is material enough to affect overall growth. This is very hard to judge so soon, and will depend in part on how much the currency works as a shock absorber. Following the announcement the NZ dollar fell around 1.% to near lows for 1. Market outlook Over July, global fixed interest markets calmed, with yields broadly unchanged. It now seems that it would take a real downturn in US data to prompt the Fed to completely step away from tapering QE. We think that we would need to see much weaker data or reemergence of global stress to get US 1 years bonds back towards.%. Equally, while the US Fed remains committed to keeping US overnight rates near zero for the next few years, it becomes more difficult for US 1 year yields to rise significantly above %. On balance, we judge that there has been a further improvement in economic momentum in the US and New Zealand. Furthermore, Europe is moving from a basket case into economic recovery, and there is scope for Australia and China to exceed the pessimistic expectations of markets. So looking beyond the immediate risk of Fonterra s product safety issues, over the mediumterm we continue to see sufficient global and domestic economic momentum to support higher bond yields. 1 Harbour Navigator: Wheying up contamination risks August 1.

6 Christian Hawkesby, Director, Fixed Interest, Harbour Asset Management IMPORTANT NOTICE AND DISCLAIMER The New Zealand Fixed Income Commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such contents constitute advice, they do not take into account any person s particular financial situation or goals, and accordingly, do not constitute personalised financial advice under the Financial Advisers Act 8, nor do they constitute advice of a legal, tax, accounting or other nature to any person.. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. Actual performance of investments managed by Harbour Asset Management Limited will be affected by management charges. No person guarantees the performance of funds managed by Harbour Asset Management Limited.

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