New Zealand 10-year government bonds are currently yielding about 4.75% while the OCR is at 2.25%, a 250 basis point gap, McDonald told an Amova investment conference.
The history of the last 20 years shows when that gaps gets that large, bond yields have fallen, McDonald said.
“We’ve been here before. Markets are anxious and uncertain about outcomes,” and that has led to mispricing of bonds.
Where NZ bond yields are currently trading implies an OCR above 4% but it’s more likely to average about 3% “unless something untoward happens.”
Yields are likely to fall, which implies out-sized bond fund returns over the next one to three years are probable, McDonald said.
He also said that if US bond yields weren’t so elevated currently, NZ long bond yields would probably be about 50bp lower than they are.
While it’s highly likely that the disruption caused by the war in the Middle East will end or at least diminish at some point, we just don’t know when, he said.
“If there was some certainty to that question, all of our lives would be very much simpler – it’s all about time frames,” McDonald said.
When oil markets do settle, the price of Brent crude is likely to settle between US$75 a barrel and US$85 from more than US$111 currently and compared with less than US$73 before the conflict began on Feb 28.
“I don’t think Donald Trump will get his wish of US$50 any time soon.”
That situation presents central banks with a dilemma about whether to hike interest rates to contain inflation expectations, but central banks can’t do anything about the price of oil.
“We know inflation will be above 1% to 3%, but we don’t know by how much.”
That will mean central banks will be looking closely at wage and price-setting behaviour.
Mortgage interest rates have already moved higher, which could mean central banks need to do less.
At the moment, the spike in oil prices is a price shock. If it becomes a supply shock, that would likely create a deflationary environment, so the worse the situation gets, the more the economy will slow and the less likely it is that the official cash rate (OCR) will rise, McDonald said.
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