President Trump likes debt. Before his election he described himself as the “king of debt”. It should therefore come as no surprise that he has not favoured the increase in US interest rates. He recently described the US Federal Reserve (the “Fed”) as having “gone crazy”. The problem for the president is that he may not get his way as global monetary policy support appears likely to diminish further in 2019 on gradually increasing inflation and falling unemployment.
Indeed, irrespective of the recent share market weakness the Fed seems committed to (i) further increases in its Fed Funds rate (analogous to New Zealand’s Official Cash Rate) and (ii) continuing to unwind its balance sheet, i.e. not reinvesting maturing bonds bought through its quantitative easing programme.
That provides a challenge for Mr. Trump because the US needs buyers for the treasury bonds issued to fund the larger budget deficit his tax reforms have generated. In recent years non-US investors have been ready buyers of US treasury bonds. US bonds offered a higher return away from low or even negative interest rates. Looking forward, as global central bank monetary policy tightens, the demand from these investors for US bonds may fade. That could push US treasury bond yields even higher to tempt others into the void left by the Fed and these offshore investors, pushing up Mr. Trump’s cost of interest payments.
Notably the Bank of England and Bank of Canada have both already lifted interest rates. Even the European Central Bank has indicated it will raise interest rates next year and should stop increasing its quantitative easing (“QE”) in December. The Bank of Japan has also publicly questioned the ongoing efficacy of its QE programme.
Tightening global monetary policy has already claimed some victims, with some developing economies suffering financial stress due to increased financing costs of their USD debt liabilities. Looking closer to home, Australasian bond markets have thus far been relatively immune, but the risk is growing that may change next year.
Since the Global Financial Crisis Australasian bonds have posted notable outperformance relative to US treasury bonds. The chart below illustrates that 10yr AU and NZ bond yields are now over 0.5 percentage points lower than 10yr US treasury yields, a 30-year low. Irrespective of our expectation that the NZ Dollar and AU Dollar central bank cash rates will remain on hold for some time, (see our previous blog here) the risk remains that higher offshore bond yields could reduce demand for Australasian government bonds. In NZ over 55% of the government bonds on issue are held by offshore investors. Should offshore inflows to the NZ bond market reduce, it could push NZ bond yields higher, even if the government maintains its fiscal discipline.
Not dissimilar to the challenge facing Mr. Trump that could provide a headwind for the NZ government, especially if it looks to loosen the fiscal purse strings. It would also be a headwind for those NZ asset prices benefiting from cheap money. That includes the property market but also the bond and share market. Active management of interest rate exposures in investment portfolios will therefore remain crucial to navigate what are likely to be increasingly volatile returns. To that end, even accounting for the move in offshore yields already in place, and the fact that US treasuries will continue to benefit from flows away from risky assets on share market volatility, we will continue to limit the offshore interest rate exposure in our bond and diversified funds.