The New Zealand Dollar Could be in For an RBNZ Surprise on Wednesday

Above: RBNZ Governor Adrian Orr. File Image © Pound Sterling, Still Courtesy of Financial Services Council NZ

- NZD on offensive ahead of RBNZ but wobble late Tuesday.

- TD Securities says RBNZ could surprise with 2nd rate cut.

- Projects cut would send NZD/USD lower to 0.6550 target.

- But Morgan Stanley looks for steady rates and higher NZD.

The New Zealand Dollar was trading higher against a weakened Dollar and Pound Sterling Tuesday, ahead of the latest interest rate decision from the Reserve Bank of New Zealand (RBNZ), but analysts at TD Securities say the Kiwi could be in for a rude awakening in the early hours.

New Zealand's Dollar, while still up for the session, ceded some of its gain back to its U.S. rival late Tuesday after Federal Reserve (Fed) rate setter James Bullard said that market expectations for a 50 basis point interest rate in July are "overdone".

Bullard is a renowned monetary policy 'dove' so is one of the Federal Open Market Committee voters who's most likely to favour a significant reduction in U.S. interest rates, but his message was loud and clear Tuesday. Markets had bet heavily the Fed will cut rates by 50 basis points in July ever since last week's interest rate decision.

Tuesday's late setback for the Kiwi Dollar may have set the scene for Wednesday when Reserve Bank of New Zealand Governor Adrian Orr is expected to announce the bank's latest interest rate decision. The RBNZ cut its cash rate to a new record low of 1.50% in May. 

"We look for the RBNZ to shift to an explicit easing bias at its upcoming meeting, which should pave the way to a cut at the August meeting. This much is already priced in the curve, so we think it would be more of a surprise that the RBNZ did not commit to such a stance already (that could lead to an unwelcome kiwi rally)," says Mazen Issa, a strategist at TD Securities. 

Above: NZD/USD rate shown at daily intervals.

Consensus is for the RBNZ to leave its interest rate unchanged at the new low of 1.5% in June, so financial markets will take their cues from the tone of the accompanying statement, assuming there's no surprise from Governor Adrian Orr. The decision is due out at 03:00 am London time.

However, the statement on its own could be enough to hurt the Kiwi if Orr says anything inside that indicates financial markets are being too conservative in their expectations for future RBNZ interest rate cuts. 

And there's good reason to think that Orr might want to take the opportunity to shake up the market, especially the Kiwi Dollar, which has risen 1.4% against its U.S. counterpart over the last week. 

"With central banks now tripping over themselves to out-dove and prospectively out-cut each other, we would not put it past Governor Orr to induce a surprise cut this week. This leaves us inclined to fade NZDCAD rally into 0.88." Issa says.

Above: NZD/CAD rate shown at 4-hour intervals.

Orr cited years of below-target inflation and an economic outlook that is insufficient to encourage a return of the consumer price index above the midpoint of the 1%-to-3% target band as being behind the May decision to cut Kiwi borrowing costs to a new record low. 

New Zealand's inflation rate has been below the 2% threshold for a number of years already and now the global and Kiwi economies are slowing, which could mean even less inflation and more rate cuts up ahead.

"Although GDP and CPI are close to the Bank's targets, we cannot rule out the possibility of the Bank delivering a surprise cut at this meeting to show it is ahead of the curve," says Prashant Newnaha, a colleague of Issa's. "If the RBNZ cuts, the NZD should should drop 1% or more. From current levels this implies a 0.6550 target."

The governor might be tempted to attempt to put a dent in the New Zealand Dollar on Wednesday because a stronger currency can reduce inflation by making imported goods cheaper to buy.

He might also be open to a surprise interest rate cut, given the Federal Reserve, European Central Bank and Reserve Bank of Australia have all already cut their interest rates or are on the verge of doing so.

Without action from the RBNZ to offset the currency impact of lower interest rates elsewhere, the Kiwi could strengthen and further reduce New Zealand inflation. Reserve Bank of Australia governor Philip Lowe noted on Monday that his bank is having to contend with this new dynamic. But not everybody anticipates Kiwi losses Wednesday.

Above: Pound-to-New-Zealand Dollar rate at daily intervals, alongside NZD/USD rate (blue line, left axis).

"NZD could receive an additional boost from the RBNZ rates decision tonight. Markets are expecting a dovish outcome, with around 20% probability of a 25bp rate cut priced for this meeting. However, the RBNZ is unlikely to deliver a cut or change its easing bias drastically, in our view," says Hans Redeker, head of FX strategy at Morgan Stanley. 

Changes in rates are only normally made in response to movements in inflation, which is sensitive to economic growth, but impact currencies because of the influence they have on capital flows and their allure for short-term speculators.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

Morgan Stanley's Redeker says there's little reason for the RBNZ to want to weaken the Kiwi currency on Wednesday, citing it as one of the reasons he's not worried about New Zealand Dollar losses going into the event. 

"Importantly, despite the dovish turn by the Fed, the NZD TWI has only appreciated 1.4%,and the 2Q average is 0.8% weaker than the RBNZ's forecast, suggesting little pressure for them to act to prevent FX appreciation from weakening the inflation outlook. With a full 25bp rate cut almost priced for August, the RBNZ would need to signal an imminent rate cut to cause NZD depreciation. As such, the risks are skewed to the upside for NZDUSD over the meeting," Redeker writes, in a note to clients Tuesday.

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