Expectations and the term premium in New Zealand long-term interest rates

As a small, indebted economy, it is important to understand how financial market shocks in the rest of the world transmit to New Zealand. A key channel is long-term interest rates, which are highly correlated across countries. A sharp increase in international long-term bond yields would affect a range of New Zealand interest rates, including mortgage rates. I use a term structure model to analyse the drivers of long-term interest rates in New Zealand. Movements in long- term interest rates can be decomposed into a component that reflects expectations about the future path of short-term policy rates, and changes in the term premium. The term premium is the compensation investors require for the risk of holding interest rate securities. The term premium in New Zealand 10-year bond rates has trended down since the 1990s. Stable inflation, a strong domestic economy, and low global bond market volatility are likely to have contributed to a low term premium in recent years. The New Zealand term premium is highly correlated with foreign yields, which may present some challenges for domestic monetary policy. Specifically, an increase in the term premium, even if driven from overseas, would be associated with a fall in domestic inflation and activity over the following year. Monetary policy may sometimes need to offset term premium shocks to achieve domestic macroeconomic objectives. The model presented in this note provides estimates of the drivers of long-term yields that can be monitored at a high frequency, and a framework for thinking about movements in long-term interest rates and their implications for policymakers.