Tuesday 20th March 2018
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New Zealand government bonds are trading at lower yields than comparable US Treasuries for the first time in more than two decades, reflecting a Federal Reserve that's expected to continue hiking interest rates this week while the Reserve Bank stays on hold.
The yield on New Zealand's 10-year government bond was recently at 2.85 percent, up from 2.75 percent at the end of 2017, while US 10-year Treasuries are at 2.86 percent, having climbed from 2.41 percent at year-end, according to Reuters data. That's seen the spread or yield premium move 1 basis point in favour of the benchmark US bond, a turnaround from the start of the year when the spread was 37 basis points in New Zealand's favour. A year ago, the New Zealand 10-year bond was yielding 82 basis points more than its US counterpart.
Fergus McDonald, head of bonds and currency at Nikko Asset Management, said the last time the New Zealand 10-year bond yield had been below that of the US 10-year bond was in late 1993 to 1994, prior to the 1994 bond market sell-off, but "it didn't last for very long, and it's certainly unusual that we're at these narrow spreads."
On Thursday, the Reserve Bank is expected to maintain the official cash rate at 1.75 percent, while markets are expecting a quarter-point rate hike from the US Federal Reserve, with a decision due earlier that morning, taking the Fed Funds Rate target range to between 1.5 percent and 1.75 percent. The Reserve Bank hasn't indicated it plans to lift the OCR any time soon, while the Fed has projected as many as three rate increases in 2018 and some analysts are picking there may be a fourth. McDonald says the reversal of New Zealand's traditional bond yield premium won't dent investor demand too much.
"Fixed income markets like safety, stability, predictability. For longer bonds, and 10 years is a longer bond in a New Zealand context, they're looking at it to be a little bit of a protector against inflation," McDonald said. "Nobody's quite sure when the Federal Reserve will stop putting up interest rates, and how fast they'll get there, and that uncertainty is priced into the term premium for interest rates in the United States."
There was US$14.7 trillion of US Treasury securities outstanding as at Feb. 28, dwarfing the size of New Zealand’s government borrowing. As of last month, there was $79.4 billion of New Zealand government bonds and bills on issue, of which foreign investors held $43.4 billion, or 57 percent of those available in the secondary market, according to Reserve Bank data. That’s down from 60 percent in February last year.
Offshore investors have traditionally demanded a premium to own New Zealand government bonds to take account of risks including limited liquidity versus US debt.
Imre Speizer, a senior market strategist at Westpac New Zealand, said comparing the two government bonds was "not quite comparing apples with apples", with swap yield curves a better comparison where the 10-year swap hadn't yet crossed over. The US 10-year swap was recently at 2.89 percent, while the NZ 10-year swap was at 3.18 percent.
"We've gone from being the darling of the high-yield world to no longer being that," Speizer said.
"Our central bank on hold means the interest rate for the front few years of our yield curve is not going to do much, though for a bond investor that's not a bad thing," Speizer said. "Central banks which have started hiking rates means bondholders at the front of the yield curve will suffer capital losses, but here they can get some comfort that they won't experience those losses. "So far appetite has held up, a number of indicators we follow are telling us that the flow into NZ government bonds has been reasonably solid."
Warren Potter, senior portfolio manager at AMP Capital, said AMP's expectation is to see the negative spread widen a bit more in the short term, then reverse over the longer term when the Reserve Bank starts tightening monetary policy.
"New Zealand won't be immune from things that are driving US rates higher, it eventually will have an impact and the Reserve Bank will have to adjust," Potter said. "New Zealand has to borrow quite a lot of money offshore and our rate has to stack up globally, otherwise we might see some flows out of New Zealand government bonds into US Treasuries."
"The Reserve Bank has said its expectation is it's not going to move til mid-2019, that's what we think as well, but even ahead of that move the market will start pricing for that adjustment," he said. "If we get a substantial move lower in the New Zealand dollar we might get a higher inflation track, but our expectation is that's not going to happen."
Nikko's McDonald said widening deficits could see the US government issue more debt, but it could run into difficulties if big buyers of long-dated US Treasuries such as China and Japan aren't as keen to buy, he said. "The guts of it is, certainty in New Zealand and uncertainty in the rest of the world."
If the yield on US 10-year bonds rises significantly above 3 percent, a level it last reached in December 2013 and last held above for consecutive days in 2011, that may frighten equity markets and spur appetite for US Treasuries, McDonald said.
"They are still the most deep and liquid fixed income market in the world, and they will still be bought very aggressively and interest rates will fall if we have another episode of equity market weakness," he said.
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