Roger J Kerr says interest rate differentials still matter in currency markets. But the bout between the RBNZ and the markets is stalemated at 72 USc and will need a circuit-breaker

By Roger J Kerr

The battle of wills between the local financial markets and the Reserve Bank of New Zealand (RBNZ) on how the future will pan out in respect to inflation, economic growth, interest rates, the NZ dollar currency value and the residential property market bubble is a long way from being resolved and settled.

In the blue corner, we have the RBNZ who refused to cut interest rates from March to August and caused the NZ dollar to appreciate as foreign investors took a liking to our positive interest rate return differential to other currencies. Through this period inflation continued at record low levels with the higher exchange rate cementing in that sub-1.00% annual inflation rate to last a lot longer into the future.

The RBNZ realised their monetary policy error by late July and U-turned with a special economic update, new inflation forecasts and increased LVR rules on the banks to cool the housing market.

The way was paved for the RBNZ to slash the OCR over coming months to drive the currency value lower and achieve their 1% to 3% inflation rate requirement.

The interest rate market immediately priced in two and a half 0.25% cuts to the OCR by December. Unfortunately, it appears the RBNZ lost the play-book at last week’s Monetary Policy Statement and perhaps true to form they disappointed and underwhelmed the markets with an outlook that had a much slower pace of interest rate reductions. Instead of sending the NZD/USD exchange rate lower (as was their want) they misread the markets and the Kiwi dollar spiked up to 0.7300 from below 0.7200.

In the red corner, the local financial markets took the RBNZ at the word after the late July U-turn on monetary policy settings and priced-in the two and half 0.25% interest rate decreases over coming months The markets assessed that New Zealand would need to lower its wholesale interest rate levels to much closer to those prevailing in Australia where the Reserve Bank of Australia (RBA) had dropped their OCR twice, in May and July to 1.50%. The RBNZ stated last week that the markets had over-anticipated the amount of loosening the RBNZ would do. However, the counter-argument is that if the RBNZ were serious about pushing the NZ dollar lower they had to deliver to prior market expectations and perhaps even a little more aggressive on the cuts than what the markets were expecting. The RBNZ failed to deliver to the expectations they themselves had built up in late July and thus inflation may stay stubbornly low as the RBNZ have so far failed to create the conditions for a lower exchange rate value.

The bout has evened up into something of a stalemate and impasse as the NZD/USD exchange rate ran into the brick wall at 0.7300 yet again and has quickly reversed back to 0.7200. The RBNZ statement again placed a lot of importance on their own survey of inflationary expectations as a determinant going forward as to how much more they might need to ease monetary conditions to push actual inflation upwards. Lower inflationary expectations over the next quarter would provide the evidence the RBNZ needs to be more aggressive on slashing the OCR to 1.50% and make more of an impact on the forex markets to sell the Kiwi dollar. Disturbingly, the RBNZ inflationary expectations survey is dominated by fund managers, bankers, brokers and economists, instead of importers, retailers, manufacturers, food producers and services provider who are the actual price-setters in the economy.

Whether the NZD/USD exchange rate can return back to the previous 0.6500 to 0.7000 trading range over the remainder of 2016 will now largely depend on the interest rate decisions of the Federal Reserve in the US and less so on the RBNZ here.

Recent US economic data has been somewhat mixed, with stronger jobs growth and rising wages suggesting rising inflationary pressures and thus the need for an interest rate hike, whereas manufacturing and retail data has been less supportive of such a Fed decision.

From a US dollar currency movement perspective whether the Fed lift their interest rates in September or December may not make a lot of difference. The FX markets will price the expected future changes/conditions into the currency rates today, so even if the Fed do hold off until December the US dollar should still make gains now.

Much will depend on the US August Non-Farm Payrolls employment numbers in early September. Another strong increase above 200,000 jobs on top of the strong June and July figures may be enough to convince the Fed and would send the US dollar strengthening below $1.1000 against the Euro. Further monetary loosening in Europe should also contribute to Euro weakness, USD strength over coming months.

Recent gains by the Aussie dollar to 0.7700 against the USD should prove to be short-lived once again as the rise in some metal/mining commodity prices such as iron ore does not look sustainable against no change in underlying global supply and demand conditions. On a more positive note, international whole milk powder prices are recovering on news of levelling off or lower milk supply volumes in Europe and New Zealand. Longer term into late 2017, higher dairy prices should return the Kiwi dollar into the 0.70’s instead of remaining in the 0.60’s.

Interest rate differentials do drive currency values and the gap between US and European interest rates points to a EUR/USD exchange rate closer to $1.0500, not the current $1.1170. The expected reducing gap between NZ and Australian interest rates suggests a NZD/AUD cross-rate closer to 0.9000, not the current 0.9370 level. Both situations suggest a movement down in the NZD/USD rate over coming weeks/months to below 0.7000. 

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Daily exchange rates

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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com