The New Zealand economy entered 2017 in fine fettle.  Despite dairy prices at GlobalDairyTrade auctions having fallen 3.8% since their early December level, the price index is up a massive 66% from its low point in the first quarter of 2016, with whole milk powder prices having risen 77% over the same period.  Both price measures hit 2.5-year highs earlier in December.

Having now passed the current season’s peak, dairy production levels in New Zealand for the six months to November were down 3.0% on the same period last year.  This drop in output has contributed to the recovery in prices, but it’s not only New Zealand farmers who have been cutting back production.  European milk output in the six months to November were 2.4% below 2015 levels, while Australian production plunged almost 10%.  These figures give us confidence that the rally in dairy prices will be largely sustained – particularly given that current whole milk powder prices of US$3,283/tonne are close to the US$3,200/tonne that was being talked about a year ago as a long-term “equilibrium” price.

Dairy’s renaissance joins ongoing growth in the construction and tourism sectors, while recent GDP figures show that economic growth has also broadened and most service sectors are enjoying a healthy rate of expansion.  ANZ’s business confidence and own-activity measures remain well above their long-term averages, while consumers’ feelings about their current financial situation are their most positive since 2007.

Against that backdrop, attention must now turn towards the future upward trajectory of interest rates.  Thinking about rising interest rates might seem a little odd given that it’s been only a couple of months since the Reserve Bank last cut the official cash rate, to 1.75%.  What’s more, a few months ago, several forecasters were anticipating that the OCR could drop to 1.5%.  But the healthy performance by the New Zealand economy has been joined by prospects of stimulatory fiscal policy in the US, which is driving up inflation expectations and longer-term interest rates internationally.  The strengthening outlook for the American economy also contributed to the US central bank’s hike in the Fed funds rate just before Christmas.

The Federal Reserve’s rate hike was accompanied by projections of three further rate increases during 2017.  This outlook felt a bit like the one presented at the end of 2015, when the Fed was projecting four rate hikes for 2016 – only two increases eventuated.

Inflation expectations in the US, as measured by the gap between real and nominal ten-year government bond rates, ratcheted up from 1.7% to almost 2.0%pa between the presidential election in early November and the week before Christmas.  Our graph shows that US inflation expectations and nominal ten-year government bond rates in December reached their highest levels since September 2014, and inflation expectations in New Zealand were at a 16-month high.

Graph 1

The rise in nominal bond rates in New Zealand has been less dramatic – they ended 2016 at roughly the same level as they had started 2016.  But ten-year rates here still lifted 130 basis points over the last four months of the year.

These trends have flowed through into rises in fixed mortgage rates.  Between late October and Christmas, increases ranged from 13 basis points for two-year rates to 30 points for four and five-year rates.  These movements are not enough to really affect the housing market yet, but with mortgage holders stretched, particularly in Auckland, the spectre of rising interest rates could be troubling when their current fixed rates come up for renewal.

Looking towards 2017, we see three other major areas to keep an eye on.