If there was one pervasive assumption in financial markets at the start of this year it was probably the view that global government bond markets were overpriced and interest rates could only go one way and that way certainly wasn't down. There was renewed talk of "certificates of confiscation", "the great rotation into shares", blah blah blah.
As is often the case whenever there is a consensus on what will happen the opposite occurs. That has been the case thus far in 2014. US ten year treasuries started the year at 3.02% and as at the time of writing they have fallen to 2.54 per cent, generating a return, year to date in US dollar terms, of 5.2 per cent. In any event disparaging the intelligence of the global government bond market is a big call even for local private bankers with five years experience and an AFA qualification - there are quite a few trillion dollars involved so this sort of money attracts serious brainpower and let's be honest the bond market has less historic incidents of "irrational exuberance" than some stockmarkets we could mention.
The question before the panel today therefore is : "What if US bond yields are where they should be"? This novel view was explored by Pimco's Bill Gross the other day and it has important implications for NZ and in particular where the Reserve Banks takes our Official Cash Rate (OCR).
Let's see what Bill had to say but acknowledge at the outset that Mr Gross is a bond fund manager so is naturally favourably disposed to this asset class. Let's also submit the fact that he is almost the Warren Buffett of the bond world with the best long term track record in the business.
Mr Gross reckons that we are in a period of unprecedented high leverage in many economies so it is important to realize that interest rates and the servicing cost of debt are critical. See attached graph. He notes that the great recession of 2008 occurred because central banks raised interest rates to too high a level which got the sub-prime mortgage and high yield bond sectors into trouble. Back in the 2004-2006 period the US Federal Reserve raised short term interest rates to 5.25 per cent following a doctrine that short term interest rates should peak in any tightening cycle at around the rate at which the economy grows.
The mistake according to Mr Gross was that the Fed failed to appreciate that, because of the extent of borrowings in the economy, the system couldn't tolerate this level of interest rate. His theory is that because borrowings are still high short term interest rates are not going anywhere near 5.25 per cent again and he cites a research paper by the US Federal Reserve entitled "Measuring the Neutral Rate of Interest " which suggests that a neutral cash rate might be as low as .5 per cent currently and just 1.5 per cent assuming long term inflation of 2.0 per cent. He also cites other research by Pimco which concludes that a 1.0 per cent Fed funds rate was long term neutral to stabilise inflation at 2.0% and nominal growth in the economy at 5.0 per cent.
In its April newsletter Longview Economics show that world private sector non-financial debt has increased from about 126 per cent of GDP in 1970 to more than 250 per cent of GDP in early 2014. That is unprecedented. Mr Gross's musings are relevant because the Fed funds rate, like the OCR in NZ, helps to price bonds, property and shares and just about everything else. In the US the futures markets anticipate a 4.0 per cent Fed funds rate in 2020 but if the neutral policy rate was only 2.0 per cent then bonds instead of being overpriced would be cheap. That has implications for NZ investors.
Just the other day the Governor of the Reserve Bank announced that the official cash rate was being increased to 3 per cent. During questioning he gave "forward guidance" that it would be 4% by the end of the year and probably 5 per cent within two years. He further stated that a neutral OCR is estimated to be 4.5 per cent.
This seems excessive and it is a huge move in today's leveraged world. For a start a 5% OCR implies ten year Government bonds at 6 per cent and maybe higher. Compare this risk-free rate with the 6% un-conflicted experts tell us is the long term prospective return from global equities. Why would local investors bother with the risk. Similarly if corporate bonds are priced at a margin of 1 per cent or 2 per cent above Governments we could be looking at yields of 8% from investment grade corporates.
Imagine the influx of hot money coming into New Zealand if those yields are dangled in front of international investors. The NZ dollar won't go down in this environment. The futures market for the Fed Funds rate in the US suggest that that rate will be 2 per cent by 2017 so a 5% OCR is a huge 3 per cent margin.
In a paper entitled "Neutral interest rates in the post-crisis period" and in a speech by the assistant Governor to the NZ Institute of Chartered Accountants, the Reserve Bank acknowledges that neutral interest rates ie ones which are neither overly stimulatory or causing a contraction in the economy, may have changed and be lower in the future. However a neutral OCR of 4.5 per cent still seems very high compared to the yield on current long term bond yields locally, let alone overseas, and the prospective return from equities.
Why would an institutional investor buy NZ 10 year government bonds yielding 4.3 per cent in the knowledge that a neutral OCR (and thus the 90 day bill rate) is 4.5 per cent? There is much lower interest rate risk in 90 day bills than there is in 10 year bonds. Thankfully the Reserve Bank seems to be alert to the possibility that neutral interest rates may be a bit less than 4.5 per cent and does stress that there is a considerable margin of error around its 4.5 per cent forecast.
However the most insidious impact of high local interest rates is that the cost of capital for NZ investors will be much higher than that for overseas investors so we will see the natural and logical sale of NZ assets including our farming industry to overseas investors. When assessing the net present value of a company or farm, because overseas investors have a lower cost of capital, they will use a lower discount rate which will generate a higher net present value in their models than those of NZ investors. Simply put assets will be worth more to overseas buyers than NZ sellers. We talked about this problem when we looked at the Synlait, Uruguay Farms and Fletcher Forests takeovers in the past.
This is a huge issue for New Zealanders but the Reserve Bank's high OCR policy inadvertently underwrites the sale of NZ companies to overseas investors when their real concerns seem to be centered on the NZ residential housing market. Raising interest rates to sort out the housing market is a blunt instrument. Demand for residential seems to be coming from overseas so NZ needs to implement specific measures, as Canada has done, to address this issue rather than raise interest rates which inevitably penalizes investment throughout the whole economy.
When addressing Parliament's Finance and Expenditure committee John McDermott, Assistant Governor and Head of Economics at the Reserve Bank said that the issue of foreign investors buying NZ assets has a lot to do with NZ's low savings rate "NZers have not been saving enough for their own investment needs for over 40 years (the length of time our current account has been in deficit). This lack of savings results in structurally higher interest rates in NZ than in the rest of the world.
All the Reserve Bank does is move the OCR around this level to stabilize output and inflation". That is a good point. The current account balance is the sum of the balances of trade and goods and services and investment income. Another way of looking at it is that the current account measures what a country saves less what it spends or invests. The hope would be that with immigration changing the demographics of NZ, KiwiSaver and improvement in the terms of trade that our current account balance will improve in the future.