In last week’s MPS the RBNZ raised its interest rate forecasts by around 50bps
-   We still see a first OCR hike in March next year, and expect floating rates to be 2.0% higher in two years
-   As the market holds a similar view, wholesale fixed rates sit close to ‘break-even’ relative to expected floating rates
-   However, fixed rates offer protection against the risk that we under-estimate the peak in the OCR cycle
-   We also see fixed rates continuing to rise in the coming two years
-   Declining bank funding costs have provided relief recently but are now unlikely to decline significantly

The Reserve Bank sounded less relaxed in last week’s Monetary Policy Statement (MPS). It acknowledged at least some of the broad inflation risk we see, as the economy picks up steam. It emphasised the positive risks to the outlook as much as the negatives.

Please see attached for full article including tables and graphs

The Reserve Bank sounded less relaxed in last week’s Monetary Policy Statement (MPS). It acknowledged at least some of the broad inflation risk we see, as the economy picks up steam. It emphasised the positive risks to the outlook as much as the negatives.

It formally raised its interest rate forecasts. The implied starting point for rate hikes was moved forward from end Q3 to end Q2 next year. This in itself was not a surprise for a market that was (and is) already pricing a March start to the hiking cycle. But the RBNZ also lifted its entire rate track by 50bps from late 2014. In addition, it suggested the lift would have been greater, by 30bps, if not for the expected impact of imminent Loan to Value Ratio (LVR) restrictions on banks.

With reference to the NZD, the RBNZ commented the “exchange rate remains high”. However, it was notable the RBNZ did not refer to the currency as “over-valued” as it has at length, in the past. The RBNZ’s forecasts also showed a downward revision to its NZD Trade Weighted Index (TWI) track. The TWI is now seen largely flat-lining in the coming 12 months.

Floating Rate Outlook

Recent RBNZ communications have not changed our expectations for the Official Cash Rate (OCR). We continue to see a first OCR hike in March next year, from its current historic low of 2.50%. We see a steady ‘normalisation’ of the OCR thereafter to a 4.50% cyclical peak in mid-2015. Essentially, borrowers face an outlook where floating rates will be around 2.0% higher by two years’ time, in our view.

A wide array of indicators now point to strong growth ahead e.g. business and consumer confidence surveys and the Performance of Manufacturing and Services indices. Momentum is seen building across regions and sectors, from agriculture to construction. Notwithstanding this, we expect this week’s Q2 GDP release to be technically weak (-0.2%) partly reflecting drought impacts from earlier in the year. However, we see this as a pre-cursor to a strong 1.3% rebound in Q3.

The most recent CPI reading (Q2) remained below the RBNZ’s 1-3% target range for the fourth consecutive quarter. However, we expect Q3 inflation (released mid next month) to pick up to 1.2%y/y. We see annual inflation pushing toward 3% over the next two years. This will require rate hikes to prevent inflation breaching the top of the RBNZ’s target range.

Outlook for Wholesale Fixed Rates

Since the beginning of May, wholesale fixed rates have moved rapidly to price the outlook we see for floating rates. The catalyst has been the improving domestic outlook plus market expectations the US Federal Reserve will soon start reigning in its highly accomodative monetary policy.

There is generally greatest ‘value’ in wholesale fixed rates when the market under-estimates the path that lies ahead for floating rates. Therefore, now that market pricing is quite closely aligned to our view, we see only limited ‘value’ in wholesale rates i.e current 1-5-year wholesale rates are close to ‘break-even’ compared to paying the expected floating rate over the period (table below).

However, while the ‘break-even’ may be similar assuming our OCR forecasts are correct, the cashflows will be quite different. ‘Fixing’ now suggests paying upfront but having a known cost for the duration. ‘Floating’ suggests better cashflow up front but significant risk further out.

In addition, it would be prudent risk assessment for borrowers to analyse the maximum interest cost their business could absorb using floating rates. For example, it may be that we are under-estimating the rate at which the OCR will peak. The RBNZ’s most recent forecasts hint the peak in the OCR may be higher than the 4.50% implied at the end of their forecast period (Q1 2016). A fixed rate will mitigate this risk.

Some businesses may feel they contain a ‘natural’ hedge, in that the OCR will only be rising if the economy is doing well. In that case their own businesses will be in good shape to absorb higher interest costs. For example, for the dairy sector this argument is illustrated by the loose directional relationship shown between milk prices and rates (chart below). However, the relationship is loose and the argument is certainly not applicable to all industries.

‘Break even’ or ‘fair value’, is a quantitative assessment of where current wholesale fixed rates sit relative to forecast floating rates. It is not a forecast of where wholesale rates will sit at any time in the future.

In fact, although we see current rates as close to ‘fair’ we continue to see wholesale fixed rates on a rising trend over the coming two years. This will reflect a rising OCR over the period and our expectations for higher benchmark US 10-year bond yields. We expect the rise in short-end rates to be steeper than for long-rates (chart below). Opportunities to pay lower wholesale fixed rates will therefore likely be limited to short-term dips over the period.

We see longer-dated wholesale (10-year) fixed rates as more range-bound in the year ahead, in line with a similar view we hold for US long rates.

Bank Funding Costs

In addition to wholesale rates, marginal bank funding costs will be a key determinant of costs that borrowers face. Bank funding costs took a structural step higher in 2007-2008 in response to the Global Financial Crisis and resulting RBNZ regulations. Subsequently costs have stabilised and since late last year shown some marginal easing. This has helped offset some of the rise in underlying wholesale rates in recent months (chart below).

We anticipate that funding costs may still decline slightly further but will likely soon plateau. A continuation of the downward trend of the past few months should not be relied upon. Equally, in the absence of a spike in global risk aversion, or heightened domestic deposit competition we do not see funding costs returning to previous highs. 

Summary

We continue to see the RBNZ’s rate hiking cycle starting in March next year, and expect floating rates to be 2.0% higher in two years’ time. As the market now holds a similar view, wholesale fixed rates sit close to ‘break-even’ relative to expected floating rates. However, fixed rates offer ‘certainty’ and protection against the risk that we under-estimate the peak in the OCR cycle. We also see wholesale fixed rates continuing to rise in the coming two years. Opportunities to pay lower wholesale fixed rates will therefore likely be limited to short-term dips over the period. While declining bank funding costs have provided some relief against rising wholesale rates recently we do not see significant further declines in these costs. Some businesses may contain some ‘natural’ hedge against rising interest costs, but this assessment should be made with caution.