This article was originally written and published by Openly Investing.
“One may miss the mark by aiming too high as too low” – Thomas Fuller
Since our last deliberations surrounding the prospect of negative interest rates in New Zealand, investors have had a plethora of new information to consider. Alongside a resurgence of the pandemic globally and domestically leading to a second lockdown for the Auckland area, economic data has provided some clarity on the state of the New Zealand economy; however, there remain many unknowns regarding the path of this recession. Whilst an evident recovery in manufacturing has provided some positive momentum and sentiment, the services sector continues to languish. Central Banks have also reiterated their commitment to ensuring sufficient liquidity and other stability measures which are complimented by fiscal packages from the government in the form of business and household support.
At their quarterly monetary policy meeting in August, the Reserve Bank of New Zealand (RBNZ) discussed the appropriateness of current monetary policy settings with respect to their mandated goals of low inflation and maximum sustainable employment. They agreed that given the ongoing uncertainty of a weak economic outlook, low inflation and rising unemployment, it remained appropriate to provide additional monetary stimulus. This has proven to be prudent given the meeting was held prior to the second wave of infections and economic pressure caused by the subsequent lockdown in Auckland.
The ramifications of the second wave are significant given they have presented the New Zealand economy with an anchor to its burgeoning recovery, which was outperforming the RBNZ’s most optimistic scenario provided earlier in the year. In addition to pushing out the economic recovery, the setback also delays the day government is able to confidently reopen its borders to travel which, is so important to the NZ economy. To offset the expected weakness from the disruption brought about by the Auckland lockdown, the RBNZ expanded the Large Scale Asset Purchases (LSAP) which, alongside low-interest rates and the Funding for Lending Programme, is expected to deliver further monetary stimulus to the economy. At the August meeting, the RBNZ increased the stimulus provided by the LSAP to $100bn, up from $60bn and continued to work towards a framework for an operating environment that would allow for a negative Official Cash Rate (OCR).
The RBNZ, led by Governor Orr, has shown a willingness for both openness and innovation and as such provide timely and regular updates on their policy and thinking. In his most recent speech Governor Orr stated that “the economic shock from COVID-19 continues to evolve and remains difficult to assess in scale, duration, and impact on demand and supply.” Whilst also highlighting that the RBNZ has been able to “Exercise decision making under extreme economic uncertainty, using a least regrets approach for the current context…” It is this “least regrets” approach and the RBNZ’s recognition that these unorthodox times have called for innovative strategies and solutions which supports the view of a further easing of the OCR. They also recognise the risk associated with the banking sectors’ reduced willingness to lend when wholesale rates are negative, and state that they will ensure banks have access to direct lending from the RBNZ along with ongoing Quantitative Easing (QE) to alleviate funding pressure.
This ongoing commentary from the RBNZ and the uncertainty around the timing and path of the recovery from the global pandemic certainly heightens the probability of further reductions in the OCR. Whilst the quantum and timing of such a move are yet to be seen, this outcome would now seem inevitable with a move possibly in April 2021. This timing would allow both for previous assurances from the RBNZ that the OCR would remain at 0.25% until at least March 2021 whilst also providing further latitude to ensure the banking system is able to function in a negative rate environment or put more simply “to allow time to get all the ducks in a row!”
This assessment has led wavering forecasters to increase the probability of negative rates and with the associated change in forecasts, downward momentum in bond yields resumed and have subsequently broken through the bottom of the recent historic low.
As with any cut in the OCR, there will be an associated interest rate rally across the yield curve which presents an opportunity for capital gain. That being said, with the recent change in sentiment, some of this has already been priced into the current market and may limit these gains. Further opportunity for capital gains will be dependent on whether the RBNZ maintains a bias for further cuts or the next move is 50bps (0.5%) to take the OCR to -0.25%.
Our view has been, and remains, that the recovery from this recession will take some time, possibly as long as four to five years, and we still regard this as our central case albeit with interest rates at a lower level than originally thought. As such we have been recommending investment in bonds with a maturity of four to six years whilst maintaining a smaller exposure to longer-dated bonds to insure against this very possibility. This strategy will allow for reinvestment at higher levels as stimulus and liquidity measures are gradually removed which would lead to higher interest rates and a steeper yield curve.
Given this situation, investors with large portfolio exposures to term deposits have significant reinvestment risk as bank term deposit rates will inevitably fall considerably. Of course, this is the case with any cut in the OCR however, with the prospect of a negative OCR for a protracted period combined with cheap bank funding provided by the RBNZ the incentive for banks to offer highly competitive Term Deposit rates is further decreased.
In the current environment and the prospect of further reductions in the OCR expected, companies seeking cheap funding have been motivated to raise capital through new debt issuance. The recent paucity of issuance in New Zealand has reversed with all types of entities taking advantage of surplus market liquidity. In the past two weeks alone, there has been more than $2bn worth of new issuance in New Zealand all of which have seen considerable oversubscription. With the success of the new issuance prevalent coupled with the need of the NZ Debt Management Office to fund Central Bank and Government liquidity measures, we would expect the increased supply to be an ongoing dynamic for some time to come.
Global Fixed Income Manager
9 September 2020
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