The Reserve Bank of New Zealand has begun cutting interest rates – here’s how it could impact local markets

During the third quarter of 2024, many developed central banks kicked off interest rate cuts, beginning to reverse the aggressive monetary policy tightening that began in late 2021 to combat decade-high rates of inflation.

In cutting interest rates, most central banks said they are comfortable that inflation is on its way back to target levels, or for some – such as the Bank of England and the Bank of Canada – inflation has already reached its target rate.

For others, there is an added need for cutting interest rates: a worsening of economic conditions. This is particularly pertinent for New Zealand, where unemployment is on the rise, the economy has experienced a double-dip recession, and possibly on track for a triple-dip recession in the second half of 2024, and consumer spending has plummeted. Added to this, annual inflation, as measured by the Consumer Price Index (CPI), had dropped to 2.2% for the third quarter of 2024, down from a peak of 7.3% in 2022.

So far, the Reserve Bank of New Zealand (RBNZ) has cut the Official Cash Rate (OCR) by 75 basis points, including a 50 basis points cut in October with expectations for further cuts ahead. In fact, as of early October, interest rate markets were pricing in more than 150 basis points of cuts by the end of 2025.

With interest rates falling – and an increasing likelihood that they are headed even lower – it is set to be an interesting period for investors. Here we look at what falling interest rates could mean for your investment.

New Zealand bonds are already having a stellar period, even with just one 25 basis point cut by the RBNZ. Over the 12-month period to 30 September, bonds, as measured by the S&P/NZX NZ Government Bond Index, rose 11.9%, comfortably ahead of its global peers.

While bonds are forward-looking, meaning future moves are somewhat priced in, further interest rate cuts by the RBNZ would likely see bond yields drop further – a scenario where bonds tend to perform well. Furthermore, with economic data looking like it could worsen into the end of 2024 and into 2025, defensive assets such as bonds should find support.

“We have already seen a good run up in bonds this year, which means they are susceptible to a pullback in the short term. However, when we look at the macroeconomic backdrop in New Zealand of slowing growth, falling inflation and a weakening employment market, it is still a scenario where bonds should perform well”, Ray Jack, Credit Analyst, ANZ Investments.

At a tactical level within our multi-asset-class funds, we moved to overweight New Zealand bonds more than a year ago. Our core belief was that the New Zealand economy was showing signs of slowing, hampered by elevated borrowing costs. In turn, we believed the RBNZ would shift to an easing bias and then begin to cut interest rates – a scenario where bonds tend to perform well.

And as we have seen, this scenario has played out – and our overweight position has been a positive contributor to relative performance.

We have also held an overweight position to international fixed interest, with the belief the Fed would begin to cut interest rates as inflation continued to moderate. Like our domestic overweight position, this has been a positive contributor to performance. However, in late September, we brought this overweight position back to neutral. Given the extent of the move, we feel the risk – especially in the short term – is now skewed towards a pullback in bonds (a move higher in yields). Therefore, we felt the prudent move was to square off our overweight position.

Falling interest rates are also having a positive impact on New Zealand equity markets with the NZX 50 reaching a two-and-a-half-year high in August, driven by some solid gains since the RBNZ turned dovish in early July.

Much like bonds, equities are forward-looking, so while economic headlines may seem downbeat, investors are looking beyond the here and now and comfortable that the falling interest rates means the medium to long-term outlook for New Zealand equity prices is attractive on a valuation basis.

“The interest rate cut by the RBNZ has been positive for domestic equities because it reduces a key headwind to economic growth and increases confidence that the period of high inflation is over. In a way, what the cut has done is signal that help is on the way”, Max Lesser, Head of Equities, ANZ Investments.

Furthermore, it is important to remember that the New Zealand equity market is not necessarily reflective of the New Zealand economy. The NZX 50’s significant exposure to sectors such as utilities and real estate means it is more sensitive to changes in interest rates as opposed to more macroeconomic factors. In fact, we have already started to see some of this sector-specific performance – notably real estate, which has been one of the strongest performers since the RBNZ signalled it had finished raising interest rates.

In summary, it’s easy to get distracted by the short-term volatility in financial markets. This is particularly acute when central banks are cutting interest rates, because historically, interest rate cuts occur during time of financial stress or a general economic downturn.

However, these periods can provide opportunities. The team at ANZ Investments see these periods as good opportunities, whether it’s to buy companies at attractive valuations, or invest in bonds, which tend to outperform when interest rates fall.