The convergence to zero continues, favouring Anglo-Saxon government bonds

The Reserve Bank of New Zealand is now signalling rate cuts are possible, coming out of its last policy meeting. Its 10-yr bonds have the highest yield of all developed economy major Central Banks. Meanwhile the US Federal Reserve’s last policy statement gave no indication that its desire to tighten as early as June had changed in any way. These two policy meetings highlight two macro themes I believe will dominate markets in 2015. One is the strong dollar. The other is the convergence of interest rates to zero, with Anglo-Saxon bonds showing the greatest convergence.

The first theme on convergence favouring Anglo-Saxon bonds is one I laid out about two weeks ago. The crux of my argument was as follows: “the first and most legitimate function of government bonds in a fiat currency area is to serve as a vehicle to add or subtract reserves in the system to help the central bank hit a target overnight rate. The second function is to give holders of government obligations a return on their investment in order to facilitate that transaction. But there is no guarantee here. Bond investors are not guaranteed a return at all, as we now see. If the central bank promises to hold rates at zero in perpetuity, then interest rates will fall toward that rate across the curve because of the dominant influence the central bank plays. This is what is happening now, not just in Japan but everywhere in the developed world.”

What this means in effect is that a lowflation, low growth, low nominal GDP world is one dominated by low and declining rates for each risk free currency area asset class. In the eurozone, Switzerland and Denmark where rates are negative because of the central bank’s tax on deposits, risk free assets are moving into negative territory. This makes holding cash or investing in money market funds unfavourable. And contrary to theory, I believe these taxes add to deflationary pressure ensuring that these currency areas remained mired in lowflation and low growth. Nevertheless, rates across the curve in those currency areas are already low. They will decline but not rapidly, for the simple fact that a lot of the yield-curve flattening has been priced in.

On the other hand, there are risk-free currency areas where there is considerable room for convergence to zero. The currency wars are forcing every central bank to reduce policy rates as a means of checking the inflow of hot money seeking yield. And New Zealand’s policy rate of 3.5% stands out here. This is what the Reserve Bank of New Zealand has just stated in this regard:

The Reserve Bank today left the Official Cash Rate unchanged at 3.5 percent.

[…]

The lower oil price will have a significant impact on prices and activity in New Zealand. The most direct and immediate effects are through fuel prices, with the price of regular petrol falling from a national average of $2.23 in mid-2014 to $1.73 currently. This will increase households’ purchasing power and lower the cost of doing business.

Annual economic growth in New Zealand is above 3 percent, supported by rising construction activity and household incomes. The housing market is showing signs of picking up, particularly in Auckland. However, fiscal consolidation, the reduced dairy payout, the risk of drought, and the high exchange rate will weigh on growth.

While the New Zealand dollar has eased recently, we believe the exchange rate remains unjustified in terms of current economic conditions, particularly export prices, and unsustainable in terms of New Zealand’s long-term economic fundamentals. We expect to see a further significant depreciation.

The high exchange rate, low global inflation, and falling oil prices are causing traded goods inflation to be very weak. Non-tradables inflation remains moderate, despite buoyant domestic demand and an improving labour market.

Reading between the lines here, you can see that New Zealand is concerned about the negative impact that the exchange rate will have on growth. And the lowflation environment, exacerbated by the drop in oil prices gives the central bank room to cut rates. I believe the CB wil cut rates and that New Zealand is the best opportunity for convergence of any low risk currency area in terms of government bonds. Australia comes next and then come the US, Canada and the UK. All of these government bonds should converge to zero as the currency wars force central banks globally into a more dovish policy stance.

But then you have the tension for the Fed of the strong dollar. The data have weakened somewhat materially in my view. Jobless claims had been over 300,000 for two weeks before this past week, four of the last 5 durable goods prints have been weak and earnings misses or warnings this season have been large. All of this points to underlying economic weakness in the US that will see Q1 2015 below the 3%ish growth rate that we had risen to by last quarter. Think of the loss of the capex boom from shale oil as a material change in U.S. growth drivers which will only become evident with the passage of time. Not only will shale capex get cut but oil capex more generally, and this will have much larger implications for growth than we now suspect. Right now, the headline data look better than the forward-looking data. 

The Fed is still looking at the 240,000 average monthly addition to non-farm payrolls and the 3%ish growth of 2014 to guide policy, largely because the Fed is always reactive and behind the curve. The forward-looking data are murkier in my view. We did see a fantastic 265,000 jobless claims number today, however. The bottom line is the Fed may indeed raise rates in reaction to prior data just as the U.S. economy weakens materially. As I wrote two weeks ago, I believe hiking would mean yield curve inversion as a result.

Maybe the Fed gets it. If the economic data weaken further by March, we could see a change in the policy language from the Fed. But right now, the language says tightening bias with hikes as soon as June. So I am going to stick to June as the expected time for a rate hike. That said, I did lay out why this could prove incorrect with reasons the Fed won’t raise rates. It really is unclear at this point. Even so, the tightening bias will remain in place and I believe that means continued dollar strength.

Either way, I expect US yields to fall as the convergence toward zero gathers apace. Relative to Europe then, given the currency effect, the US looks attractive. But New Zealand’s government bonds are where I expect the greatest outperformance in the developed world.