Dire economic outlook should be positive for bonds: Nikko

The only reason interest rates remain as high as they are is because inflation is proving to be very sticky, McDonald said on Tuesday at an investment forum in Wellington hosted by Nikko.

“Every other indicator says we should have lower rates than what we've got.” Inflation in the year ended June was 6%, twice the top end of the range the Reserve Bank is supposed to target.

After the largest and fastest increase in monetary policy since the official cash rate (OCR) was introduced in 1999, we've already had the recession RBNZ said it wanted and growth in the current quarter is likely to be close to zero with the following two quarters showing “pretty subdued or negative growth,” McDonald said.

“The risk that I see going forward is not that interest rates are going to fall, it's by how much.”

And the risk for the economy is that, if the RBNZ keeps monetary conditions too tight for too long, the recession could be deeper than it needs to be, he said.

McDonald noted that the RBNZ has raised its estimate of the neutral OCR to 2.25%, which means the OCR currently is more than two percentage points higher at 5.5%.

The process of getting to that OCR level from 025% before the first hike in October 2021 has led to the largest losses on bonds in 35 years in New Zealand and the same has been true for investors in US bonds, making 2022 a real outlier.

“It has been pretty hard to make money out of bonds, but I think the wheel is turning,” McDonald says.

But after every similar episode in the past, bonds have bounced back.

He noted that even with record levels of migration inflows, the latest retail sales volume data showed a 1% drop in the June quarter.

That followed falls of 1.6% and 1.1% in the previous two quarters.

McDonald also pointed to the very weak data on the dairy industry, slowing global growth and concerns about China's economy.

In his view, the signals suggest the risk of the RBNZ starting to cut the OCR sooner than expected are rising. Last month, RBNZ signalled it expects to keep the OCR at current levels through to early-to-mid 2025.