Interest Rate Research

RESEARCH Interest Rate Research 2 March 218 NZ Bank Bill-OIS and FRA-OIS Spreads An Update Increases in US Libor-OIS and the Australian equivalent have filtered through into wider NZ FRA- OIS spreads over the past few weeks and a higher 2 year swap rate. As yet, there has been only a modest impact on the NZ 3m bank bill-ois spread (which remains much lower than in the US and Australia). The NZD FX basis has also widened aggressively, meaning NZ bank bill issuance is now much cheaper for NZ banks than swapped USD commercial paper issuance. While banks may tilt short-term issuance towards the domestic market in the future, we don t believe NZ bills-ois mechanically needs to follow the moves offshore (unless funding pressures really intensify in the US). We suspect there are constraints around arbitrage between NZ and US markets. To the extent that wider NZ bills-ois spreads means higher borrowing costs for the real economy there could, in principle, be implications for OCR expectations. However, retail fixed mortgage rates have been falling recently and we think funding conditions would need to deteriorate significantly to materially affect OCR expectations. The rise in Libor-OIS spreads does not appear to be related to an increase in the perception of bank credit risk, as bank CDS spreads remain at relatively low levels, but rather a funding issue. Australian bank bill-ois spreads have also widened sharply in recent weeks, catching up with the moves in the US. In contrast, the NZ spot 3 month bank bill-ois spread (bills- OIS) has remained relatively contained; it has widened modestly to 19 but it remains significantly below the levels in the US and Australia. USD Libor-OIS and AUD bills-ois have widened sharply 6 5 4 3 2 1 NZ 3m bank bill-ois, AU 3m bank bill-ois and USD Libor-OIS AU 3m bank bill-ois 3m USD Libor-OIS NZ 3m bank bill-ois Higher USD Libor-OIS spreads but only a modest increase in NZ bills-ois to date USD 3 month Libor-OIS has risen sharply over recent months, from a low of around 1 in November to above 5 now. The increase in USD Libor-OIS appears to have been driven by: - An increase in US Treasury bill issuance, as the US Treasury rebuilds its cash balance after the suspension of the debt ceiling. The subsequent increase in Treasury bill yields has flowed through to higher rates on other cash money market instruments, as well as Libor. - US tax reform, which incentivises US multi-nationals to repatriate offshore profits. Multi-nationals have been buyers of USD fixed income offshore in recent years (reinvesting profits), but the tax reform raises the prospect of reduced demand for US short-end paper going forward (and some may indeed be sellers of short-dated bonds to raise cash for repatriation). 211 212 213 214 215 216 217 218. Weekly averages. but NZ FRA-OIS spreads and FX basis have moved wider In contrast to the relative stability of the spot 3 month bills- OIS spread, NZ bank bill futures and FRA-OIS spreads NZ 3x6 FRA-OIS has risen much more than 3m bills-ois 5 4 3 2 1 NZ 3m bank bill-ois vs. 3x6 FRA-OIS NZ 3m bank bill-ois NZD 3x6 FRA-OIS 3x6 FRA-OIS less 3m bills OIS -1 211 212 213 214 215 216 217 218. Weekly averages. bnz.co.nz/research Page 1

Interest Rate Research 2 March 218 widened sharply last week. The 3x6 FRA-OIS spread (i.e. the 3m bills-ois spread in 3 months time) is around 31 at present, 12 above the 3 month spread. In effect, the market prices the NZ bills-ois spread to rise to levels more in-line with (but still lower than) those in Australia and the US in the coming months. The NZD-USD 3 month FX basis has also widened sharply this year, from around 1 to around 4 now, a post- GFC wide. The increase in the FX basis has coincided with the widening in US Libor-OIS relative to NZ bills-ois see chart below. The recent experience in Australia suggests that the FX basis will narrow if NZ bills-ois catches-up to US Libor-OIS. NZ 3m FX basis and FRA-OIS spreads have widened funding via USD commercial paper (and swapping the proceeds to NZD) vs. funding domestically via 3 month bank bill issuance, as shown in the chart below. 1 NZ 3m bank bill rate is much lower than 3m USD swapped % 4.5 4. 3.5 3. 2.5 2. NZD 3m bank bill rate and implied NZD cost of funding via 3m FX swap Implied 3m NZD funding cost via FX swap 3m NZ bank bill rate 5 4 NZDUSD 3m FX basis vs. NZ-US 3m Libor-OIS differential 1.5 21 211 212 213 214 215 216 217 218 3 2 1-1 3m NZDUSD FX basis -2 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 3m Libor-OIS differential US v NZ The widening in the NZD FX basis is in sharp contrast to the period around the GFC, when USD funding markets locked up, forcing banks to borrow domestically (and pushing the FX basis very negative). The widening in the NZD 3m FX basis, alongside similar moves in other major currencies, suggests that recent moves in USD Libor-OIS are not indicative of broader USD funding stress. NZD FX basis is positive, in contrast to the GFC period 1 5-5 NZD, AUD and EUR 3m FX basis swaps AUD 3m FX basis EUR 3m FX basis NZD 3m FX basis Should NZ bills-ois follow USD Libor-OIS? Historically, NZ bills-ois has been correlated with USD Libor-OIS (as shown in the chart on the first page), although the relationship is far from perfect. The relationship between NZ bills-ois and USD Libor-OIS depends on a degree of substitutability between the two markets and the ability of some market participants to exploit the arbitrage. 2 In theory, domestic banks could react to the increased relative cost of USD short-term funding by running down USD CP issuance and boosting funding in bank bills this switch in issuance patterns could push up NZ bills-ois and narrow the FX basis. The stock of short-term market funding (i.e. with residual maturity shorter than 1 year) sourced from offshore investors has been declining over the past year, which would be consistent with domestic banks running down their offshore CP programmes to some extent. 3 However, there is probably a limit to which banks would want to reduce their USD CP outstanding, as they are likely to want to retain a regular presence in the market to keep it open as a funding source in the future. And as yet, there has been no real increase in short-term domestic market funding to take advantage of the relatively low cost of NZ bank bill issuance. -1 1 The implied NZD funding cost via FX swaps assumes a NZ bank funds in USD CP at -15-2 27 28 29 21 211 212 213 214 215 216 217 218. Weekly averages. FX basis goes deeply negative during GFC NZ banks are structural borrowers in offshore capital markets, partially funding NZ s current account deficit (and accumulated stock of net foreign liabilities). The widening in the FX basis increases the relative cost to NZ banks of the same rate as 3m Libor. 2 The FX basis itself is an example of an arbitrage that exists in the market, related to a structural mismatch between the supply and demand for NZD vs. USD funding (NZ banks are structurally borrowed in USD). But there should exist market participants that can take advantage of extreme dislocations in investment or funding opportunities across borders. 3 The decrease in the stock of short-term (<1 year debt) could be related to older bank bonds maturing rather than a decrease in CP issuance. In general, banks have become progressively less reliant on short-term funding since the GFC, aided by bank regulations such as the core funding ratio (CFR). See https://www.rbnz.govt.nz/regulation-and-supervision/banks/prudentialrequirements/liquidity-core-funding-ratio for more detail. bnz.co.nz/research Page 2

Interest Rate Research 2 March 218 Stock of short-term market funding offshore v domestic 45, Stock of offshore and domestic market funding with residual maturity shorter than 1y market funding (with a maturity longer than 1 year). The decline in retail fixed mortgage rates and term deposit rates recently are suggestive of banks wanting to encourage more net lending. 4, 35, 3, 25, 2, 15, 1, 5, Domestic market funding, shorter than 1y Offshore market funding, shorter than 1y Domestic credit growth slowed in 217 4 35 3 25 1 year change in domestic credit vs. change in non-market funding and market funding >1y 1 year change in non-market funding + market funding >1y Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Source: RBNZ 2 15 1 year change in domestic credit Limits around arbitrage 1 5 The current levels of NZ bills-ois, USD Libor-OIS and the FX basis imply arbitrage opportunities to market participants with access to domestic funding markets and USD (or AUD) cash markets for investment. 4 Domestic banks are the obvious candidates who could in theory raise NZD liquidity and swap the proceeds into USD to invest in CP or lend via depos. But NZ banks may be constrained by the size and availability of credit lines to invest in USD. The relatively small size of the domestic funding market is another constraint (for instance, trading volumes in the daily bank bill rate set have averaged around $5m since early 216). Outside of the domestic banks, holders of NZ money market instruments have an incentive to sell or not roll-over short-end NZ bank paper and invest in USD (or AUD) bank CP. However, mandate restrictions may not allow some participants to take advantage of the arbitrage. Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Source: RBNZ. Domestic credit sourced from C5. Funding data sourced from L3. The surplus liquidity generated by the NZ banking system appears to have been partially recycled into NZ fixed income instruments, helping to keep NZ bank bill rates relatively low. The stock of short-term market funding has also declined over the past year (see chart below), which could be interpreted as reduced demand from NZ banks for short-term funding. The stock of short-term market funding has declined 6, 55, 5, NZ 3m bills-ois v the stock of short-term market funding Stock of market funding with a residual maturity <1y 4 35 3 25 Finally, offshore market participants funding NZD assets via FX swaps would be incentivised to fund onshore, perhaps via repo (again, to the extent mandates allow). 5 But NZGB repo rates have not widened relative to OIS, unlike in Australia, and indeed a number of bonds on the curve currently trade special in repo. 45, 4, 3m NZ bills-ois, RHS 35, 3, Mar 211 Mar 212 Mar 213 Mar 214 Mar 215 Mar 216 Mar 217 Source: RBNZ, Bloomberg. Excludes overnight funding. 2 15 1 5 Domestic banks in healthy liquidity position One explanation for the relatively low level of NZ bills-ois is that domestic banks appear to be in a surplus liquidity position. Unlike previous years, deposit growth kept pace with lending in 217 and, in addition, banks increased their long-term market funding. The chart below shows that domestic credit growth has been lower than the growth in non-market funding (largely deposits) and longer-term 4 The arbitrage trade would be to issue, or sell, NZ bank bills, swap the proceeds into USD or AUD, and invest in NZ bank CP denominated in those currencies. 5 Our colleagues in Rates Strategy in NAB believe some Japanese investors have switched to funding AUD bond positions via repo, given the increased cost of doing so via FX swaps, and the subsequent rise in AUD repo rates has contributed to pushing up 3m bills-ois there. The outlook for NZ bills-ois The key question is whether NZ bills-ois should converge to the levels implied by the futures/fra markets or vice versa. It is conceivable that the rise in NZ FRA rates could influence the rates at which banks are willing to transact in the 3 month rate set. This would be one mechanism by which NZ bills-ois could gravitate towards FRA-OIS levels. It s also possible that the proximity of quarter end, and a reluctance to gross up balance sheets, is deterring domestic banks from increasing domestic funding to swap bnz.co.nz/research Page 3

Interest Rate Research 2 March 218 into USD to take advantage of the arbitrage. Once quarter end passes, it s possible we could see more such activity, which would put some upward pressure on NZ bills-ois. Overall, we suspect it will take a more material shift in domestic banks issuance patterns (towards short-term NZD funding) or an increase in domestic credit growth to cause a large increase in NZ bills-ois. It s also not obvious to us that there are many unconstrained market participants who can access NZD funding to take advantage of the arbitrage and bring NZ bills-ois into line with the US. Of course, if US funding pressures intensify significantly, this will put upward pressure on other funding avenues for NZ banks, including domestic bank bills. But such a US funding squeeze would probably be associated with widespread increased demand for USD via FX swaps, something we haven t seen as yet. Implications for monetary policy To the extent that wider NZ bills-ois spreads mean higher borrowing costs for the real economy there could, in principle, be implications for OCR expectations. However, retail fixed mortgage rates have been falling recently, symptomatic of domestic banks being in a strong liquidity position. Retail fixed mortgage rates have been falling of late Moreover, there has only been a modest increase in NZ bills-ois and swap rates to date, so the monetary policy implications are fairly limited at present (and very much secondary to broader macro developments). In our view, funding pressures would need to worsen significantly to have material implications for monetary policy (i.e. to bring rate cuts into play). Implications for short dated NZ swap rates NZ short-dated swap rates have risen over recent weeks, in line with the increase in FRAs (RBNZ expectations have been broadly unchanged over this time). Last week, the 2 year swap rate increased to its highest level since July, although it remains well within broader trading ranges. Given our expectation that the OCR will be on hold this year, we expect that movements in the 2 year swap rate will continue to be driven by funding pressures (FRA-OIS spreads) in the near-term. One potential risk is that funding pressures intensify, NZ FRA-OIS spreads widen further, and this leads to an unwinding of received positions at the short-end of the curve, further pushing up swap rates. Higher NZ FRAs have driven up the 2 year swap % 2.5 2.4 NZ 2 year swap rate vs. 3x6 FRA and 3m bank bill 7. NZ Mortgage Rates 2.3 2yr swap 2.2 6.5 6. Floating rate 2.1 2. 3x6 FRA rate 5.5 1.9 3 month bank bill 5. 4.5 2-year rate 1.8 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 4. 215 216 217 218 nick.smyth@bnz.co.nz Source: interest.co.nz bnz.co.nz/research Page 4

Interest Rate Research 2 March 218 Contact Details Stephen Toplis Head of Research +64 4 474 695 Craig Ebert Senior Economist +64 4 474 6799 Doug Steel Senior Economist +64 4 474 6923 Jason Wong Senior Markets Strategist +64 4 924 7652 Nick Smyth Interest Rates Strategist +64 4 924 7653 Main Offices Wellington Level 4, Spark Central 42-52 Willis Street Private Bag 3986 Wellington Mail Centre Lower Hutt 545 Toll Free: 8 283 269 Auckland 8 Queen Street Private Bag 9228 Auckland 1142 Toll Free: 8 283 269 Christchurch 111 Cashel Street Christchurch 811 Toll Free: 8 854 854 National Australia Bank Peter Jolly Global Head of Research +61 2 9237 146 Alan Oster Group Chief Economist +61 3 8634 2927 Ray Attrill Head of FX Strategy +61 2 9237 1848 Skye Masters Head of Fixed Income Research +61 2 9295 1196 Wellington Foreign Exchange +8 642 222 Fixed Income/Derivatives +8 283 269 Sydney Foreign Exchange +61 2 9295 11 Fixed Income/Derivatives +61 2 9295 1166 New York Foreign Exchange +1 212 916 9631 Fixed Income/Derivatives +1 212 916 9677 Hong Kong Foreign Exchange +85 2 2526 5891 Fixed Income/Derivatives +85 2 2526 5891 London Foreign Exchange +44 2 7796 391 Fixed Income/Derivatives +44 2 7796 4761 ANALYST DISCLAIMER: The person or persons named as the author(s) of this report hereby certify that the views expressed in the research report accurately reflect their personal views about the subject securities and issuers and other subject matters discussed. No part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report. Research analysts responsible for this report receive compensation based upon, among other factors, the overall profitability of the Markets Division of National Australia Bank Limited, a member of the National Australia Bank Group ( NAB ). The views of the author(s) do not necessarily reflect the views of NAB and are subject to change without notice. NAB may receive fees for banking services provided to an issuer of securities mentioned in this report. NAB, its affiliates and their respective officers, and employees, including persons involved in the preparation or issuance of this report (subject to the policies of NAB), may also from time to time maintain a long or short position in, or purchase or sell a position in, hold or act as advisors, brokers or commercial bankers in relation to the securities (or related securities and financial instruments), of companies mentioned in this report. NAB or its affiliates may engage in these transactions in a manner that is inconsistent with or contrary to any recommendations made in this report. NEW ZEALAND DISCLAIMER: This publication has been provided for general information only. Although every effort has been made to ensure this publication is accurate the contents should not be relied upon or used as a basis for entering into any products described in this publication. Bank of strongly recommends readers seek independent legal/financial advice prior to acting in relation to any of the matters discussed in this publication. Neither Bank of nor any person involved in this publication accepts any liability for any loss or damage whatsoever may directly or indirectly result from any advice, opinion, information, representation or omission, whether negligent or otherwise, contained in this publication. US DISCLAIMER: If this document is distributed in the United States, such distribution is by nabsecurities, LLC. This document is not intended as an offer or solicitation for the purchase or sale of any securities, financial instrument or product or to provide financial services. It is not the intention of nabsecurities to create legal relations on the basis of information provided herein. National Australia Bank Limited is not a registered bank in. bnz.co.nz/research Page 5