Western Asset Fixed Income Market Update – Bond Yields Rise as NZ CPI Surprises

Market Moves – What Happened

Australian short-end bond yields have rose sharply last week in response to New Zealand posting its highest inflation print in over a decade on Monday. Both the RBNZ’s and analysts’ consensus forecasts were exceeded as CPI rose by 4.9% for the third quarter of 2021 compared to the third quarter of 2020. For the third quarter, CPI rose 2.2% marking the largest quarterly inflation print since December 2010 when CPI rose 2.3%.

These moves have placed greater pressure on the RBNZ to raise interest rates further, following the most recent hike to the country’s policy rate last month. Evidently, the market expects the RBNZ to do so. Prior to the data print, 23 basis points were priced into expectations for the RBNZ’s November meeting. This leapt above 40 basis points before settling around 33 basis points later in the week. Looking further out, there’s now 100bps of hikes priced into the next four meetings and policy rate expectations two years out sit comfortably above the RBNZ’s 2% neutral rate expectation.

The change in market expectations has been swift. Market trading in the 24 hours post the inflation print was whippy, with NZ’s 2yr interest rate swap gapping 7bps at one stage. Aussie rate moves were not as fierce but still substantial in magnitude with a 10 basis point rise in the 3yr Gov futures yield on Monday. Expectations for interest rate hikes coming sooner in the UK exacerbated rises on Monday night with the 3-year bond futures reaching levels not seen since Dec 2019.

New Zealand Inflation Components & Australian Implications

New Zealand’s inflation pressures are primarily tied to housing costs including utilities, construction costs and property rates. Rising food and transport costs have also contributed. The supply chain issues and pent-up demand in sectors such as housing construction causing much of this pressure are not isolated issues and are instructive for Australian market participants.

As economies continue to reopen, wage inflation in reopening sectors such as hospitality, alongside a lack of immigration will be a key area of focus as supply side issues dissipate. Higher inflation prints have already increased wholesale bank funding costs. Should they persist, this would have implications for mortgage rates which would impact consumers and their disposable incomes and ultimately the strength and pace of economic recovery.

In Australia, some of the inflationary pressures impacting the rest of the world are in their infancy due to recent Covid lockdowns. The tightness of labour prior to lockdowns was evident but we will need the economy to get back into swing before employment slack will be observable. Closed borders have certainly impacted New Zealand, and we suspect similar action in Australia as the two most populous States reopen.

In aggregate, Western Asset remains of the view that inflationary pressures will moderate as various disruptions ease, multiple base effects go into reverse, and (disinflationary) secular themes reassert themselves. Our Australian bond portfolios have been underweight across the mid curve out to the 10 year bond over the past two months, which has been additive to returns.

The scale of recent rises in rates now appears overdone. Market pricing implies the RBA’s rate hiking cycle will be faster than the Federal Reserve’s, while at the same time two of the RBA’s three preconditions for interest rate hikes i) CPI sustainably above target and ii) sustained wage growth, remain elusive with only iii) unemployment being below target. We have reduced our underweight duration position at the mid curve, holding a short at the 10 year and a marginal long at the 20 year bond, with the expectation that the yield curve will flatten at the ultra-long end.  

As usual, markets price for the ultimate outcome, so we suspect that government bond yields will be range-bound in the intermediate period, which will provide further opportunities for active management.