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Bonds go grizzly

Friday 21st November 2003

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Bad news for mortgage payers: if you haven't fixed yet, you've missed the bottom. With the bond bull market well and truly over, local banks are bumping up floating mortgage rates to combat the increased cost of funds.

This is even before the Reserve Bank delivers its Monetary Policy Statement on December 4.

The questions now for borrowers and lenders alike are how high will rates go and when will they peak?

Westpac was the first bank to move, this week lifting its floating rate from 7.1% to 7.25% amid climbing wholesale interest rates.

Bank bill rates are now around 40 basis points higher than in August and are expected to climb another 100 points by the end of next year on expectations the Reserve Bank will start raising short-term interest rates to hold down inflation.

It is easy to see where the concern lies: with household debt levels much higher than in past tightening cycles, the potency of interest rate moves today is also much higher.

The level of household debt is still increasing and average mortgages are 14% higher than they were last year, according to a recent ASB Bank survey.

Another troubling factor is private investors' recent enthusiasm for bond funds. Throughout the past year they have been one of the most popular homes for Kiwi mum and dad investors' money.

And as with the rush into technology shares shortly before the bubble burst in 2000, it seems many may have piled in to a sector just when it has peaked and is heading downward.

There has been a flood of corporate bonds and capital notes issues this year including Goodman Finance, Feltex Carpets, GPG Finance and Vector. But the rising bond yields are unlikely to send corporates rushing back to bank debt.

Most corporates borrow on a floating rate basis and that will not preclude them from issuing bonds or notes, says Graham Ansell, senior fixed interest manager at ING New Zealand.

For investors, the attraction of bonds is a high set rate of return at the end of a defined period. But when interest rates rise, the value of a bond falls. The opposite also applies, which is why bond investors did so well during most of the 1990s.

While the recent move up in bond yields was not a complete surprise, the size of the adjustment was beyond most commentators' expectations.

Of course, the cost investors will eventually face depends on whether the bond is held until the maturity date and on the amount of time to elapse before maturity. But if they have to sell to a secondary market they face taking a capital loss when interest rates are higher.

But as AMP Henderson chief investment officer Paul Dyer explains, the market has already priced in a considerable amount of tightening.

"The bottom line is that it was well anticipated and the collateral damage to bond holders is unlikely to be particularly great."

Conversely, homeowners who have not fixed their mortgage have missed their flip. "The time to fix one's mortgage was four months ago."

While a recent good run of official statistics has shortened the odds the Reserve Bank will raise its cash rate to 5.25% next month, governor Alan Bollard will still have to balance the impact of a rising New Zealand dollar before he puts his foot on the brakes.

The kiwi has hit fresh highs against the US dollar, prompting calls for Dr Bollard to hold fire on lifting interest rates to give some relief to struggling exporters. The rising dollar will also put a check on inflationary pressure as imports continue to cheapen.

But the bottom line for the Reserve Bank is medium-term inflation. At its last review in September the bank said the official cash rate (OCR) at 5% was still able to hold inflation within its target range of 1-3%.

However, the booming house market and the latest employment data mean there is now less headroom to absorb additional inflation pressures over the medium term.

Economists are divided in their thinking, with the most recent Reuters poll showing five out of 13 banks expect a pre-Christmas rate hike.

Deutsche Bank senior economist Darren Gibbs expects the central bank will want to see more domestic data before moving the benchmark rate higher, especially in light of the almost vertical rise of the kiwi.

Most key statistics, including third-quarter gross domestic product and the December-quarter consumer price index figures, come in after the December meeting and Deutsche Bank favours a rate hike early next year rather than next month.

More information on the state of the global economy through the US Federal Reserve will also come after the Reserve Bank's December meeting.

"It would be nice to see where the currency is likely to stabilise before the bank takes rates higher."

Bank of New Zealand chief economist Tony Alexander puts the odds at 50-50 that Dr Bollard will start to lift rates at the next opportunity. If it wasn't for the rising Kiwi dollar there would definitely be an increase on December 4, he says.

Despite the doubt, Alexander warns against any complacency among homeowners and bondholders. A tight labour market, improving commodity prices, strong migration flows and a recovering world economy mean inflationary pressure is building. That could mean the Reserve Bank might actually raise the OCR more than most people are thinking, he says.

The markets have already fully priced in a 25 basis point hike next month and at least one similarly sized hike in the first quarter of next year.

Citigroup lifted its forecast cash rate peak to 5.75% by the June quarter, a reverse of the 75 basis points easing in the first half of this year. It has also brought forward its forecast timing for the next OCR lift from March to January 29. It still believes it would be "tactically tricky" for the Reserve Bank to justify such a swift change in direction if it moved rates up next month.

By waiting until early next year, the Reserve Bank also allows businesses breathing space between accounting for the higher Kiwi dollar and higher cash rates, Citigroup senior economist Annette Beacher says.

Central banks in Australia and the UK have already begun their tightening cycle and economists expect further increases in the cost of borrowing before the end of the year.

A sudden improvement in the US employment picture has also turned attention to the Federal Reserve. Financial futures markets are ramping up the odds of a rate hike by the end of April.

Most economists expect no change before June but some are starting to wonder how long the Fed will keep its benchmark rate at the current 45-year low of 1%, even with low inflation in tow.

"They've got a lot of tightening to do to get their rates back to neutral," BNZ's Alexander says.

It has been a difficult few months for bond markets globally, as signs of economic recovery have pushed investors in search of better returns in stock markets. The rise in bond yields since July has coincided with a general rise in share prices in major markets and in New Zealand.

Investors have been selling bonds and buying shares, possibly reflecting a growing confidence that a global recovery is well under way. On the other hand it could be cause for concern if the higher borrowing costs stall the current growth and send the economy into reverse.

Borrowers of three-year money have seen their cost of funds increase the most, ING's Ansell says. Even though the cash rate has yet to move higher, the rest of the yield curve has climbed in anticipation.

A bank issuing mortgages when the government rate was 4.7% in June would have been able to fund at a bit over 5%. Now with February 2006 bonds at 5.93% the funding costs are probably up closer to 6.4%.

The current lift in yields is already being compared to 1994 ­ often considered as the mother of all increases ­ when three-year bonds climbed from 5.5% to about 9%.

"This one in relative terms is probably smaller but it actually came from a lower starting yield and is still probably about the fourth largest increase in interest rates from the low to where we are now."

The rise here has been nowhere near as extreme as in the US where bond rates have increased at break-neck speed, bushwhacking some investors.

After hitting a 10-year low of 3.1% in mid-June, US 10-year bond yields hit 4.5% on July 31, before easing slightly. This has shifted US long-term mortgage rates to 6%, rising from only 5.2% in June, which was the lowest rate in half a century.

"So we probably don't have as much to sell off as the US and our market has been anticipating for the past six months higher interest rates."

However, fixed-term investors have suffered a loss in capital values and are considering whether they should cut their losses, economists say.

Most global fund managers who are bearish on bonds have been looking for opportunities to short their fixed-interest portfolios relative to the benchmark.

The nervousness has caused more than $US40 billion to be shifted out of bond funds ­ a serious leakage considering bonds are supposed to be safe.

Meanwhile, New Zealand bonds should continue to outperform the US'.

"We are expecting the spreads to narrow back in again so we are looking at a 10-year yield at the moment of 6.19% and in three months' time around the 6.5% mark," Deutsche Bank's Gibbs says.

The expectations are that US yields will track up toward 5% from their current rate of around 4.31%.

"Once the Reserve Bank starts tightening, the market will start to factor in the eventual slowing of the economy and eventually the next easing."

The worldwide rise in bond yields could be a healthy sign that the global recovery is well under way and, according to some observers, the timing for New Zealand could be quite good.

While the New Zealand export sector might struggle because of the higher currency, an emerging global economy could lead to increased demand for Kiwi products, Ansell says. "One could offset the other."

But bond holders who missed the sell signals a few months ago could face more paper losses in 2004 if the OCR rises and the long bond market stays bearish.

Investors have been selling bonds and buying shares, possibly reflecting a growing confidence that a global recovery is well under way.

On the other hand it could be cause for concern if the higher borrowing costs stall the current growth and send the economy into reverse.

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