WRAPUP 2-NZ bond selloff piles pressure on central bank

* C. bank denies talk of emergency meeting over bond selloff

* Bond yields ease after 80 bps spike, swap surge

* Current account deficit grows, limits policy responses

* IMF acknowledges dilemma, suggests quantitative easing (Adds details, analyst quotes, updates prices)

By Mantik Kusjanto

WELLINGTON, March 26 (Reuters) - New Zealand bond yields jumped on Thursday, prompting the central bank to deny talk it was holding an emergency meeting over a two-week debt market selloff that threatens efforts to shore up the ailing economy.

Bond prices have been tumbling since the central bank said on March 12 it may not cut interest rates much further for fear of deterring investment needed to finance the second-heaviest foreign debt burden in the industrialised world.

Only Iceland, which imploded under the weight of the global financial crisis last year, had more net external debt as a percentage of GDP among the OECD group of rich nations.

Five-year yields have surged 80 basis points in two days and the New Zealand dollar jumped more than 1 percent as investors began to anticipate higher interest rates than they had previously expected.

Moves in both markets are tightening the squeeze on New Zealand's economy, with the firmer kiwi dollar making exports less competitive and higher bond yields influencing the cost consumer loans.

The central bank is torn between pressure to lower interest rates to cushion an economy shrinking at the fastest pace in 18 years and the need to keep the yield on New Zealand's currency attractive enough to lure foreign investment.

The International Monetary Fund acknowledge the dilemma in a report released on Thursday, but called for lower interest rates and said New Zealand may have to consider quantitative easing -- a policy that could involve buying government bonds -- should that become necessary. [ID:nSYD442774]

"This is a time when monetary conditions in New Zealand need to be significantly easier than where they were a week ago, and rates have gone spectacularly higher. It's just very wrong," said AMP Capital Investors head of fixed interest, Grant Hassell.

If the current squeeze in debt markets continues to push funding costs higher and threatens growth, the RBNZ may be forced to take action, with possible options including talking down rates, sharply cutting its cash rate, or buying back longer-dated government bonds, Hassell said.

SWAPS

The central bank denied market speculation on Thursday that it would hold an emergency meeting over the spike in bond yields .

The RBNZ cut interest rates to a record low of 3 percent on March 12 to stimulate the economy but Governor Alan Bollard said New Zealand needs to "retain competitiveness in the international capital markets", signalling easing was nearing an end.

Home buyers have rushed to refinance mortgages at low, fixed interest rates amid expectations rates may not go much lower.

Banks scrambled to hedge their growing exposure to interest rate rises and piled into the illiquid swaps market, helping drive the biggest three-day spike in five-year interest rate swap in 14 years.

"We saw a lot of paying pressure from bank mortgage books and corporates rushing to hedge," said ANZ-National senior economist Khoon Goh."I expect things to settle down once these flows clear up.

Falling investment income helped widen New Zealand's annual current account deficit in the fourth quarter to nearly 9 percent of GDP, data showed on Thursday. [ID:nWEL487349]

In the OECD, only Spain, Portugal, Greece and Iceland have higher current account deficits. Only Iceland topped New Zealand's national debt burden of 86 percent of GDP as measured by a negative net international investment position.

On Friday, the RBNZ is expected to report that economic activity fell for the fourth straight quarter at the end of 2008, shrinking at the fastest pace in almost 18 years. [ID:nWEL433556]

The IMF expects the New Zealand economy to contract by 2 percent in 2009, with a gradual recovery over the medium term.

RUNNING FOR COVER

The sharp jump in bonds yields is pushing funding costs and mortgage rates higher, which will further tighten the screws on the economy. Four banks announced mortgage increases Thursday, with Westpac the first to move its two-year rate above 6 percent, according to website www.interest.co.nz.

The yield on five-year government bonds fell 7 basis points to 4.58 percent after the RBNZ denied it was holding an emergency meeting. The yield had jumped as high as 4.79 percent during the session.

The New Zealand dollar , a favourite of foreign investors for its high yield, rose a third of a cent. [FRX/]

The often illiquid swaps market, where banks go to hedge their financing exposure, bore the brunt of the action.

Two-year swaps rose 26 basis points to as high as 3.99 percent, before settling back after RBNZ statement. They had started the week at 3.4 percent. The key five-year swaps rate spiked 37 basis points to as much as 5.31 percent versus 4.43 percent on Monday.

"The swap market moves have been brutal with local banks competing with each other for term deposits and taking derivative insurance ahead of their cash raising," said Sean Keane of Triple-T Consulting in Wellington.

"The banks are also seeking to stay ahead of the huge wave of fixed rate maturities that are due to be refinanced throughout this year."

Around 80 percent of New Zealand home loans are at fixed rates, with about a quarter expected to fall due this year.

(To see a graphic on surging New Zealand swap rates, click on: https://customers.reuters.com/d/graphics/NZ_RTSWP0309.gif) (Additional reporting by Gyles Beckford, Adrian Bathgate, Eric Burroughs and Umesh Desai; Graphic by Catherine Trevethan; Writing by Kim Coghill; Editing by Dayan Candappa)