There has been a bit of coverage lately about the fact that New Zealand 10 year bond yields have dropped to around, or just slightly below, those in the United States. Here is the chart, using monthly OECD data, of the gap between the two.
Since interest rates were liberalised here in the mid-80s, the only other time our 10 year rates have been lower than those in the United States was in late 1993 and very early 1994. That phase didn’t last long. Bear in mind that back then we were targeting an inflation rate centred on 1 per cent – lower than the US, and lower than the Reserve Bank of New Zealand is charged with targeting now.
As the chart illustrates, the spreads moves around quite a bit, but the recent narrowing in the spread looks to be significant – it is (roughly) a two standard deviation event. Then again, so is the narrowing in the short-term interest rate spread. Usually our short-term interest rates are well above those in the United States, but by later this year it is widely expected that their short-term interest rates will be higher than ours. When that sort of reversal is expected to last for a while, it will be reflected in the bond yield spread as well.
The Federal Reserve’s policymakers expect to raise the Fed funds rate to, and even at bit above neutral, in the next year or two (“longer-run” in the chart below is a proxy for FOMC members’ view of neutral), while there is nothing similar in our own Reserve Bank’s published projections.
I’ve made considerable play of the persistent gap between our real interest rates and those abroad. Do these recent developments suggest that if there was a problem it is now just going away?
Well, the gap between our bond yields and those in some other advanced countries has also narrowed. Even the gap between Australian bond yields and our own – a gap which has been remarkably stable over 20 years – is narrower than it was (although all else equal their higher inflation target should be expected to result in Australian yields typically exceeding our own).
But here is the gap between our 10 year bond yields and those in some other small inflation-targeting OECD countries.
There doesn’t seem to be anything out of the ordinary going on there (and 10 year bond yields in Switzerland – like those in Japan and Germany – are a bit constrained by being almost zero already).
And here is the gap between New Zealand’s 10 year bond yields and the median of yields in all those countries the OECD has data for for the entire 25 year period.
If one simply focuses on the last 15 years – when our inflation target was increased to 2 per cent (midpoint) – the current spread is not very different to the average for that period.
There simply isn’t much sign of the persistent gap between our real long-term interest rates and those in other advanced countries going away.
In fact, dig just a little deeper and even the story vis-a-vis the US is a bit less encouraging. Both countries now have long-term inflation-indexed government bonds, the yields on which are a pretty good read on long-term real interest rates. US government inflation-indexed 20 year bond yields are currently about 0.9 per cent (even with pretty wayward US fiscal policy). The Reserve Bank reports that our 17 year indexed bond yesterday yielded 1.82 and our 22 year bond was yielding 2.0 per cent. A full percentage point gap on a 20 year bond – even if a bit less than it was – still adds up to an enormous difference over time. Markets aren’t convinced New Zealand and US real interest rates are sustainably converging any time soon (and, to those who want to throw in claims that the US is bigger or central to the system or whatever, recall that US bond 10 year yields are currently among the highest in the OECD – in other words, it is quite possible for small advanced countries to have lower interest rates, over long terms, than the US).
The other thing markets don’t appear convinced about is that the Reserve Bank will achieve the 2 per cent inflation target (set for it again this week). One can proxy this by looking at the gap between inflation-indexed bond yields (real yields) and nominal bond yields.
Here is the US version, using constant-maturity yields for the real and nominal series.
For the last year or so, markets have again been behaving as if the Fed is likely to deliver inflation around 2 per cent over the next 10 years.
But here is the (cruder) New Zealand version. I’ve just used data on the RB website – their 10 year nominal government bond yield, and the yields on the two indexed bonds either side of 2028 – one maturing in September 2025, and the other maturing in September 2030. Right now, 10 years ahead is almost exactly halfway between those two maturity dates.
Halfway between those two lines, for the latest observation, is a touch under 1.3 per cent. It is a long way from the target of 2 per cent, and the gap is showing no signs of closing.
There are two challenges it seems:
- if the government is at all serious about beginning to lift productivity growth and close the productivity gaps, they need to think a lot harder – and be willing to do something about – the things in the policy framework that continue to deliver us much higher real interest rates than those in other advanced countries,
- and the new Governor has some work to do if he is to convince people that he is really serious about delivering future inflation averaging around 2 per cent. Since the government itself just renewed that target, it should concern them – and their representatives on the Reserve Bank Board – that the target doesn’t appear to be taken that seriously by people investing money who have a direct stake in the outcome.