Two weeks ago the Treasury's debt management office got away an issue of six-year government bonds at an average yield of 1.82 per cent, just 7 basis points above the overnight official cash rate.

It is only the second time in many decades, if ever, that government bonds — other than inflation-indexed ones — have been issued at a yield with a 1 in front of the decimal point. The other time was in January.

Even 10-year government stock is trading at a yield around 2.1 per cent.


When delivering the Reserve Bank's monetary policy statement last month, governor Adrian Orr was asked what the bond market, with a yield curve as flat as that, was saying about the outlook.

"Either they are expecting very, very low growth or quite low growth and low inflation," he said.

He went on to say that one of the biggest questions global financial markets were struggling with is where the neutral long-run interest rate is now. That is the rate that is neither stimulatory nor contractionary.

"But 2 per cent to us feels too low," Orr said. "It's not a sustainable long-term position in our projection framework." So the Reserve Bank expects nominal bond yields to rise, not just here but internationally.

It could be for a good reason, because the market expects sustained real growth and normal inflation levels, Orr said.

"Or they could rise for negative reasons. People could wake up one morning and think 'Wow. I might not get my money back at these levels of debt'," he said.

"Our projections are the former." As it is, the market evidently does not see much risk of higher inflation and therefore higher short-term interest rates in the near or medium term.

The swaps curve has a normal shape, that is, longer maturities command higher interest rates to compensate for the greater risk of holding longer-dated securities rather than successive shorter-term ones.


But the incline is pretty gentle by historical standards. At the time of writing, the one-, two- and three-year swap rates are sitting at 1.86 per cent, before rising to 2.38 per cent 10 years out.

"Currently the curve says the OCR is not going to do much. There's not much inflationary pressure," said Westpac's senior market strategist Imre Speizer.

He also points to the information in the yields at which inflation-indexed bonds are trading.

The 2025 inflation-linked bond now implies a break-even average inflation rate over that period of 0.91 per cent and at the long end (a 2040 maturity) implies 1.12 per cent, Speizer said.

As consumers, we might like the sound of such subdued inflation, but were it to eventuate, it would suggest pretty weak economic growth and a sustained squeeze on firms' pricing power.

The international context to all this is that more than 10 years after the global financial crisis, the world is still heavily medicated in terms of monetary policy.

Central banks' policy interest rates remain near the emergency levels they were slashed to then (by 5.75 percentage points in New Zealand's case), the only significant exception being the United States. Longer-term rates have trended relentlessly lower and spreads have compressed.

This is powerful medicine and it has serious side effects: a build-up of debt, inflated asset prices and the mis-pricing of risk.

According to the International Monetary Fund's global debt database, which covers some 190 countries, the combined debt of governments, corporates and households by the end of 2017 stood at US$184 trillion or a record 225 per cent of global gross domestic product.

For advanced economies it was 266 per cent of GDP. New Zealand's debt-to-GDP ratio was 205 per cent, reflecting a relatively low level of government debt.

But before we get smug about that, household debt at 92 per cent of GDP is high by international standards and by historical standards too (in 1990 it was 28 per cent of GDP).

Also, a high proportion of New Zealand's debt (a net 52 per cent of GDP) was, and remains, owed to foreign lenders, another source of vulnerability.

We saw that when the crisis hit in 2008 and the offshore credit markets on which we depend, and which currently smile upon us, threatened to freeze and the Government had to put in place a wholesale funding guarantee scheme for the banks.

In its February statement the Reserve Bank reflects on some of these international risks, in particular that many major economies have limited "policy space" to respond to future downturns.

"Most central banks have policy rates at historically low levels ... In addition government debt levels are high in many economies, limiting the fiscal response to any future downturn."

High debt levels and elevated asset prices increase the vulnerability of borrowers and debt markets to rising interest rates, particularly if driven by a sudden rise in risk spreads, the Reserve Bank warned.

"The rise of leveraged loans in the corporate sector, that is, loans to highly indebted corporations with minimal creditor protections, is a particular concern. As such, a significant disruption in financial markets or the global growth outlook could have wide-reaching effects."

To be clear, the Reserve Bank is not forecasting Global Financial Crisis II: The Sequel. But it is clearly right to recognise a risk, 10 years into an economic expansion and when global growth is slowing, that we get sideswiped again by developments in the other 99.8 per cent of the world economy.

In that eventuality the current benign pricing we see in the bond market will with hindsight look like myopic complacency.

So while it is tempting to argue that when the Government can borrow so cheaply and there is so much un-met need about, it should shed the self-imposed fiscal straitjacket of its debt target and fill its boots, there is a case for guarding the space for fiscal policy to respond to the next shock.

Especially when there are so few bullets left in the bandolier of conventional monetary policy.