Eyes fixed on the policymakers

In our latest fixed interest commentary Harbour Asset Management director of fixed Mark Brown focuses on what the central banks are doing in New Zealand and around the world.

Sunday, November 10th 2013, 11:24AM

by Harbour Asset Management

Policymakers are still running the bond market

“I used to think that if there was reincarnation, I wanted to come back as President or the Pope... But now I would like to come back as the bond market. You can intimidate everybody.” James Carville, Former advisor to President Clinton.

For a long time, James Carville’s line has been one of our favourite financial market quotes. The idea behind the comment is that the bond market imposes constraints on poor government, particularly with regards to fiscal management. Governments need to finance their activities and to do so, the buyers of government debt will want to see credible fiscal policies. This concept played out dramatically in Europe over the last few years, with Greece the most notable amongst a group of nations where government bond yields surged higher due to deterioration in the fiscal position.

Indeed, in Europe, the primary focus of the policy debate has been around the connected issues of economic growth and fiscal management. The bond market punished countries that seemed unwilling to embark on some sort of austerity program, provided that austerity didn’t put unacceptable stress on the economy and society in the short term.

With European stress as a recent backdrop, it has been fascinating to observe that US Treasury Bond yields fell while the budget and debt ceiling negotiations have played out. In the European crisis yields and expected volatility rose amongst the stressed countries. It is telling that for the United States the opposite happened during the debt ceiling saga. We think this is because the crisis in the US was self-made and its impact on monetary policy was more important.

Chart 1: US Government bond yields - falling in October through government shutdown

US government bond yields

Chart 2: Expected volatility in the US bond market declined

US politics appears to have become increasingly partisan, with ideological differences between the Democrats and Tea Party faction of the Republicans far greater than we see between the two major political parties in New Zealand. In October, as the US government went into partial shutdown, and debt ceiling negotiations stalled, investors raised concerns about the US Treasury market and even the US Dollar’s status as the global reserve currency. Critics included the Chinese government, who own 7.5% of outstanding US government debt.

Might they or other foreign holders jettison the US Dollar in favour of other currencies?

Would they sell Treasuries, sending yields higher and thereby impose stress on the economy and equity market?

Foreign investors did reduce holding of Greek, Spanish and other countries debt in 2012.

In October, these fears were unfounded. One reason that yields didn’t rise was because the bond markets’ more immediate preoccupation is with the Federal Reserve’s signaling around tapering bond purchases under their quantitative easing (QE) program. The government shutdown was affecting release of economic data, making the task of assessing the state of the economy more difficult. There is also a sense that the government paralysis was affecting firms’ investment and employment plans. The Fed also commented that the rise in mortgage rates, driven by the rising bond yields over the last quarter, would also be having an impact on the housing market. The combined effect of these influences was that the market concluded that QE tapering would be deferred.

The end result is that at present, Fed policy expectations are having the dominant influence on bond yields. The scenario where ongoing political stalemate undermines confidence in the US Dollar’s position as the reserve currency seems to be just a remote tail risk for now. However, it is possible that foreign governments accelerate the diversification of their reserves investments over time, although the choice of viable alternatives is limited.

Reserve Bank mindset is becoming clearer
Ever since Graeme Wheeler replaced Alan Bollard as Reserve Bank Governor, market commentators have speculated about whether he was a natural ‘dove or ‘hawk’. The introduction of LVR rules has added to the challenge of understanding and anticipating RBNZ policy moves.

We feel the market is getting to a point of greater understanding of these issues. Firstly, it seems it’s misguided to label Wheeler either a dove or hawk. His communication to date appears to be evenly balanced. More relevantly, we see the Reserve Bank grappling with some interconnected issues and trying to use their limited toolkit to address those issues.

The elevated housing market poses risks to financial stability, the economy and the inflation outlook. Targeting this issue in isolation by hiking the OCR is too simplistic, especially as inflation is still low (despite a rise to 1.4% year-on-year in September) and hiking rates is likely to push an overvalued NZ Dollar even higher.

In this context, the introduction of LVR rules is quite understandable, even though it is a tool New Zealand has no experience with. While the aim of LVR is primarily to address financial stability goals, the Reserve Bank has observed that it is affecting the trading banks lending behavior and new mortgage business has slowed. This gives some scope for hikes in the Official Cash Rate to be deferred. This is useful from a currency perspective, as no other major central bank is looking at hiking rates anytime soon.

The OCR review on October 31 confirmed that hikes to the OCR will most probably commence by mid-2014. Signalling from the Reserve Bank appears to be becoming more predictable. This is likely to reduce volatility in the New Zealand fixed income market.

Market outlook
In the near term the consolidation in bond markets, following the aggressive rise in yields seen from May to August, may continue. Central Banks appear willing to hold back from any tightening in policy for now, as data is not providing a compelling reason to move with urgency.

However, economic data are improving and inflation is no longer at very low levels. At some point a return to normal monetary policy settings will be appropriate and we expect that market rates will move higher again when the market senses that hikes (or tapering) are imminent.

Mark Brown is a director of fixed Interest at Harbour Asset Management

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