A Checklist for a Bond Market Sell-off New Zealand Fixed Income Monthly Commentary February 2013 Christian@harbourasset.co.nz +64 4 460 8309 Just like 2011 and 2012, the start of a new year has again prompted predictions that this will be the year of a sharp bond market sell-off. Interest rates rose in January, as the RBNZ ruled out the chance of a rate cut in NZ, and as risks abated from the European crisis and the US fiscal cliff. With NZ inflationary pressure subdued, we see the RBNZ on hold for 2013, keeping short-term interest rates relatively anchored. In our opinion, more conditions are now being met in our checklist for a rise in global long-term interest rates. However, we expect any rise in long-term interest rates (and steepening in yield curves) to be modest while nominal growth remains subdued and the US Federal Reserve continues Quantitative Easing (QE). A time for reflection The start of the year is a natural time for reflection in financial markets. At the start of this year, the key questions that investors are asking themselves are: Can Australasian equities continue their strong run from H2 2012? 1 Will 2013 finally be the year of the big global bond markets sell-off? Many commentators predicted a savage bond market sell-off in both 2011 and 2012, yet bond yields fell in each year to new record lows, and as a consequence bonds produced stellar absolute returns in 2011 and solid returns in 2012. To thoroughly address the question for the year ahead, Harbour Asset Management believes it is important to breakdown the drivers of different parts of the yield curve, and to build a checklist of the conditions you need to see for interest rates to increase substantially. 1 See Harbour Australasian Equities Commentary, Continuing rally on data and FOMO, Feb 2013.
In New Zealand, it is the monetary policy stance of the RBNZ that will determine the level of short-term interest rates, and global bond markets (particularly the US) that will drive the level of long-term bond yields in New Zealand and elsewhere. The RBNZ will remain on hold in 2013 In New Zealand, we have a new central bank Governor keen to build credibility with the market and underscore his inflation fighting credentials. In this spirit, the Official Cash Rate (OCR) review at the end of January was a relatively hawkish take on inflation pressures. 2 Most notably, it acknowledged the frothy Auckland housing market and put out an explicit warning that the Bank does not want to see housing demand getting too far ahead of supply. 3 However, our interpretation was that, rather than signal imminent rate hikes, the OCR review was designed to stop the market pricing in rate cuts. And this was the end outcome, with Overnight Indexed Swap (OIS) market moving from pricing a small chance of an OCR cut in mid 2013 to a small chance of an OCR hike by the end of 2013. While the housing market and forward looking household and business confidence indicators have undoubtedly improved and point to a rosier outlook, there are plenty of reasons to keep the RBNZ on the sidelines: Annual inflation has been below the bottom of the RBNZ s 1-3% target range for 2 quarters, and inflation expectations remain anchored at low levels. Economic growth slowed through the end of 2012, with Q3 GDP coming in at 2.0% yoy, below expectations and with downward revisions to past quarters. NZ unemployment has been stubbornly high around 7.0% for the past year, with weak employment growth, and depressed labour market participation. NZ credit growth is still very modest, as most households remain cautious and take the opportunity to deleverage their balance sheets. The NZ government continues to run a tight fiscal policy, with public sector job and spending cuts to keep NZ off the radar of rating agencies. The NZ dollar reached a new post GFC high of 76.5 on a TWI basis, suppressing inflation on traded goods and hurting export and import competing industries. 2 Harbour Navigator, The return of open mouth operations by the RBNZ, 31 Jan 2013. 3 Harbour Research: Will the RBNZ use macro-prudential tools to cool the housing market?, Jan 2013. 2
The Reserve Bank of Australia retains an explicit easing basis, as our largest trading partner attempts to navigate an eventual slowdown in mining CAPEX. With this subdued backdrop, despite the sabre rattling about the housing market, the RBNZ concluded that they forecast (inflation to come) slowly back towards the 2 percent target from its current decade low. In our view, not enough conditions are yet being met for the RBNZ to need to hike rates (Table 1). Consistent with that, most local economists are still expecting for the first RBNZ rate hike to be at the end of 2013 or beginning of 2014. Table 1. Checklist for RBNZ rate hikes Key Questions 2013 1. INFLATION Is inflation high? No 2. ECONOMIC ACTIVITY Is growth and employment high? No 3. EXCHANGE RATE Is the exchange rate falling? No 4. DOMESTIC OUTLOOK Is the domestic outlook improving? Yes 5. EXTERNAL OUTLOOK Is the external outlook improving? Yes (excl Australia) Tempting the ghost of global inflation In our opinion, in 2013 there is more danger that a sell-off in fixed interest markets is driven by developments in foreign markets, leading to a rise in global long-term bond yields, including New Zealand and Australia. In other words, a steepening of yield curves. While the new central bank governor at the RBNZ is attempting to build his inflation fighting credentials, his counterparts at the US Federal Reserve, Bank of England and Bank of Japan are all doing their best to tempt the ghost of global inflation. After spending 30 years with inflation fighting having the top priority, in one way or other, these central banks are now all giving more priority to growth in the real economy. 3
The US Federal Reserve has introduced the Evans Rule which gives priority to generating jobs as long as inflation forecasts remain below 2.5%. 4 ; The Bank of England has looked through inflation being above its target for most of the past 3 years (and further into its forecasts); and The Bank of Japan has upped its target from 1% to 2%, with its governor facing intense political pressure to deliver. One of the main factors that kept global bond yields at record lows in 2012 was an intense flight to safety around fears of a breakup in the Euro and fears that US politicians would take their economy and financial markets over the fiscal cliff. As these risks have abated, the US 10 year bond yield has risen from 1.70% at the end of 2012 to 2.00% at the end of January 2013. First, US politicians managed to negotiate a muddle through scenario for fiscal policy at the beginning of January. 5 And then in the middle of January we received news that the funding positions of European banks were better than expected, as many repaid emergency ECB liquidity facilities early. In our view, moving into 2013 more conditions are being met for a significant rise in global bond yields (Table 2). Table 2. Checklist for global bond yields rising Key Questions 2013 1. VALUATION Are bonds expensive? Yes 2. MACROECONOMIC Are economies recovering? Yes 3. MONETARY POLICY Is monetary policy tightening? No 4. RISKS Are risks abating? Yes (just) 5. ASSET ALLOCATION Are funds flowing out of bonds? Yes (first signs) In our opinion, the main factor continuing to keep global bond yields low is the sheer weight of continued Quantitative Easing from central banks. The US Federal Reserve has made clear that, while inflation remains in check, its primary objective is to drive unemployment down to 6.5%. During January, US unemployment ticked up to 7.9%. Therefore, it seems most likely 4 Harbour Navigator, US Fed regime change: the new Evans Rule, 13 Dec 2012. 5 Harbour Research, US elections and fiscal cliff: hold on for a bumpy ride, 2 Nov 2012. 4
that, despite the recent momentum in the US economy, the printing presses at the US Federal Reserve will remain on full speed through 2013. So we expect continued QE to cap a sharp rise in bond yields for now. 6 However, while financial markets are cognisant of the old saying don t fight the Fed, they are also inherently forward looking. There is clearly a strong incentive to correctly anticipate when the Fed will start backing away from QE, and to judge whether the Fed will overcook the economic recovery and generate a bout of higher inflation. We believe that, as global economic data continues to improve through 2013, these questions will gain even greater scrutiny, and that we will see an eventual rise in global long-term interest rates towards more normal levels. Implications for NZ fixed interest While the January OCR review delivered a relatively hawkish tone, our interpretation was that its primary objective was to rule out rate cuts. Given relatively subdued local inflationary pressures, it is more likely the RBNZ keeps the OCR on hold through 2013. With the front of the yield curve relatively anchored by the RBNZ, we see a greater risk of rise in interest rates being driven by global long-term bond yields. While our checklist of conditions does not point to an imminent sharp rise in interest rates in H1 2013, we do believe that makes sense to begin preparing for a steepening in global yield curves. Christian Hawkesby Director, Head of Fixed Income, Harbour Asset Management 6 Harbour Navigator, A goldilocks US recovery and FOMO, 4 Feb 2013. 5
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 2008, 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. 6