Only nine months ago Treasury put low odds on the need for unconventional monetary policy (UMP) in NZ.
“We do not think there is a case for deploying UMP on current forecasts,” the November 2019 Treasury paper says. “Both Treasury and the Reserve Bank [RBNZ] are forecasting the [official cash rate] OCR to stay positive over the forecast horizon.”
Regardless, Treasury laid out a theoretical framework for when a negative OCR might, on the off chance, become necessary.
“Interest rate cuts of 300 to 600 basis points have been required in previous New Zealand economic downturns, but with the OCR at 1.0%, cuts of this size will not be possible,” the Treasury analysis says. “The OCR cannot decline far below zero.”
Treasury’s theory is about to be tested, sooner than expected.
In August the RBNZ put investors on notice with its clearest signal yet that the OCR would have a minus sign attached in the near future.
According to David McLeish, Fisher Funds head of fixed income, the RBNZ announcement cranked up the dovish rhetoric higher than expected.
McLeish said as well as emphasising the likelihood of a negative OCR, the RBNZ upped its target large-scale asset purchase program for government bonds to $100 billion – above the consensus view of $90 billion.
“That was a positive surprise for the market,” he said. “For fixed income managers, the RBNZ message it that intends to get interest rates down now, regardless of not meeting its dual objectives [of mild inflation and low unemployment].”
The implied downward trajectory of NZ interest rates is also a signal for bond managers to load up on duration. McLeish said even if long-term interest rates fall just 10-20 basis points, NZ bond portfolios stand to book solid capital gains.
He said, for example, for a bond portfolio with an average nine-year duration every 1 per cent fall in interest rates would see a 9 per cent capital gain.
“Even a 20 basis points fall still creates meaningful capital gains,” McLeish said.
The latest RBNZ move reinforced Fisher’s weighting to duration rather than triggering an abrupt strategic pivot.
“We haven’t really made changes [to the NZ fixed income portfolio],” he said.
While the RBNZ confirmed its policy of keeping the OCR at its current 0.25 per cent until March next year, McLeish said it also reiterated a “hard deadline” for local financial institutions to have their systems tuned for negative rates.
In a note published last week, Harbour Asset Management fixed income and currency strategist, Hamish Pepper, argues that in spite of the RBNZ pressure, local interest rates could be hitting a wall.
“Once Thursday’s regular tender of government bonds was out of the way, the market obliged [the RBNZ], taking yields over 10 basis points (bps) lower, while offshore markets headed in the opposite direction,” Pepper says. “New Zealand bond yields are now into what we consider to be ‘expensive’ territory vis-à-vis other markets, notably Australia, so we think that further falls in yield may be hard to come by.”
However, AMP Capital NZ head of investment strategy, Greg Fleming, says the local bond market remains more appealing than offshore fixed income for other reasons.
In the AMP quarterly strategic outlook last week, Fleming says: “Our view on NZ bonds remains much more positive than our outlook for global debt, particularly because there appears to be little attention being paid to the ultimate effects of simply pushing central bank financial liquidity into government stimulus programmes.
“It therefore seems that sovereign debt restructurings and write-downs are a future danger, one that is inadequately reflected in yields and in the demand for ‘safe-haven’ bonds, at present. Cash and local exposures are able to be monitored with more clarity, and we will continue to favour them accordingly.”
AMP Capital NZ is underweight global bonds and foreign currency, the outlook shows, while taking above-benchmark positions on cash and ‘alternative growth’: it remains neutral on all other asset classes, including local bonds.
“It is unlikely that we will contemplate lifting our bond holdings in the near future, given their historically low yields and comparatively limited scope to improve overall portfolio returns,” Fleming says.
McLeish said Fisher considers the NZ economy remains in a “repair phase” where reduced interest rates are needed to spur a recovery.
Even before COVID-19, he said the local economy was on a downward trend that has been accelerated, and probably extended, by the pandemic.
“With very mediocre growth and inflation forecast, we remain overweight duration,” McLeish said.
How much further negative interest rates can stretch duration, though, remains moot.
Just before the August RBNZ announcement, the NZ 10-year government bond yield was about 75 basis points, compared to a -45 basis points on German bunds.
“We still could have a long way to travel,” he said.
Harbour’s Pepper says the latest RBNZ estimated ‘unconstrained’ OCR (a measure of effective real interest rates) sits at -1.2 per cent for the September quarter but sinks to -2.4 per cent by the middle of 2021.
He says a comparative ‘shadow’ short-term interest rate metric hovered around -1.1 per cent at the end of July, “broadly consistent with the RBNZ unconstrained OCR forecast for this quarter, but also suggesting additional work needs to be done to achieve a rate of -2.4% next year”.
Assuming NZ financial institutions have their systems ready in time, which is not guaranteed despite the RBNZ December deadline, the great UMP experiment with negative interest rates could go live early in 2021 – answering a question posed by Treasury last November.
“If interest rates become significantly negative, people may withdraw their money as cash,” the Treasury paper says. “The lowest feasible interest rate is the Effective Lower Bound (ELB). The ELB in New Zealand is unknown.”