New Zealand bonds underperform, although there may be a silver lining – Clive Smith


New Zealand bond investors have suffered over the past two years as the local market has significantly underperformed global bond markets. This underperformance is clearly illustrated by the significant negative return achieved on New Zealand bonds over the past three years compared to a modest positive return in global bond markets, i.e. approx. -1.4% p.a. compared to +0.2% p.a. respectively for the three years ending April 2020. Although there are a series of factors that have contributed to this result, one of the most important is the position of the Reserve Bank of New Zealand (RBNZ) in the monetary cycle compared to other central banks. Fortunately, it is precisely this difference in relative positioning in the monetary cycle that provides a potentially silver lining for the New Zealand bond market going forward.

To better understand the dynamics at work, it is useful to briefly recap the events caused by the COVID-19 pandemic and the impact they have had on the policy reaction functions of central banks. In response to the pandemic, many central banks around the world have launched quantitative easing programs to support their respective economies in the face of supply-side shocks and the adverse effects of government policies aimed at mitigating the spread of the virus and its derivatives. The most recent issue arising from these supply shocks has been an increase in inflation due to supply-side disruptions. These supply-side disruptions have been exacerbated by rising energy prices resulting from Russia’s invasion of Ukraine and associated global sanctions. Although inflation rose well beyond the inflation targets of central banks, including the RBNZ, officials were prepared to consider this when setting policy based on the idea that the surge in inflation was transient. As central banks watched rising inflation, central bank reaction functions focused on the real economy – notably the unemployment rate and potential wage inflation – to gauge underlying inflationary pressures. longer term.

In New Zealand, the economy, due to a range of factors, was in a better position to recover as the world moved into a post-lockdown environment. Part of the reason is that New Zealand hasn’t seen the rise in unemployment that we’ve seen in other countries, including the United States.

The lesser negative impact on the unemployment rate has not only put the New Zealand economy in a stronger position to rebound from the lockdown, but has also led to increased price pressures in the housing market. Although New Zealand is not the only country to see rising property prices as a byproduct of quantitative easing policies, it has become more politically sensitive. As a result of this heightened political sensitivity, in February 2021 the Minister of Finance issued guidance which “requires the Bank to consider the impact of its actions on government policy to support more sustainable house prices, in particular by curbing investor demand for the existing building stock. , which would improve affordability for first-time home buyers.

It is against this backdrop that the RBNZ began raising rates from the low of 0.25% in October 2021. More importantly, not only did the RBNZ begin to raise rates, but the pace at which it raised its rates have been quite rapid, with the official cash rate hitting 2.0% in May 2022. Such a pace of rate hikes signaled the RBNZ’s intention not only to unwind quantitative easing, but also to anticipate rate increases to provide sufficient flexibility in the future. Specifically, the RBNZ noted in its April 13, 2022 announcement, aptly titled “Advanced Monetary Policy Tightening”, that “a larger move now also offers more policy flexibility going forward in light of the highly uncertain global economic environment”.

By raising rates early and aggressively, the RBNZ has put itself at the forefront of central banks when it comes to interest rate normalization. While central banks such as the US Federal Reserve and the Reserve Bank of Australia are only beginning to raise policy rates, the RBNZ is at least six months ahead of its peers. While on the positive side this provided the RBNZ with the desired policy flexibility, on the negative side it also pushed longer duration bonds in New Zealand higher ahead of other countries. It is this timing difference that has provided a tailwind to the New Zealand bond market and contributed to the significant underperformance over the past two years.

The point to note is that the timing difference between central banks in the pace of interest rate normalization is just that: a timing difference. While at the margin there may be differences in “neutral” cash rates associated with the realization of central bank policies, there is little reason to believe that there are material differences for central banks. of developed countries. While there is much debate on the subject, and only real-world experience will prove where it is, there is a convergence of opinion that the neutral cash rate lies somewhere around by 2.0%. If this turns out to be the case, then the RBNZ will be one of the first central banks to normalize spot rates back to the neutral spot rate. For investors in the New Zealand bond market, this offers a silver lining, as the underperformance so far is partly due to the RBNZ being ahead of other central banks in this normalization process. This allows New Zealand bonds to outperform as the RBNZ slows the future pace of rate hikes as other central banks around the world try to catch up. So just as the relative pain endured by bondholders due to the RBNZ being ahead of other central banks was anticipated, so too could the benefits going forward.

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