New Zealand Dollar Strength at Risk of RBNZ Rate Cut

The New Zealand dollar is presently enjoying a period of strength on the FX markets with markets content to bet that no interest rate cut is due from the RBNZ this week. They risk being wrong though.

The New Zealand dollar is firmly in charge against the majority of its G10 rivals having notched up gains on the back of strong economic data and a softening in sentiment towards both the US dollar and pound sterling.

The currency was the best performer in the G10 group of currencies for the week ending June 3rd while the pound earned the accolade of worst performer.

No doubt, New Zealand’s superior basic interest rate of 2.0% was one of the reasons yield-starved money poured into NZD. 

This interest rate will however come into focus in the second week of June when the Reserve Bank of New Zealand (RBNZ) meets to decide on whether or not to cut the OCR once more.

A base rate of 2.0% means New Zealand assets enjoy strong demand from global investors who are looking for returns in a world dogged by chronically low interest rates.

The flow of investment funds to the country ensures the NZD has enjoyed a strong bid for years now.

The RBNZ on the other hand wants both the exchange rate and interest rate lower - therefore cutting the interest rate achieves both aims.

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Lower interest rates will help stimulate New Zealand inflation which has fallen notably in 2016 and poses a risk to the country’s economic growth profile. Soft inflation sees wages stagnate and corporate profits come under pressure. By lowering the interest rate, the thinking goes, companies will be encouraged to invest more and this will stimulate the economy.

The high exchange rate (by historical standards) meanwhile acts as a drag on global demand for New Zealand’s goods and services. The New Zealand dollar exchange rate complex is said to be 5% above the RBNZ’s own year-end projections as per the RBNZ’s March MPS.

“We expect the RBNZ to cut the OCR by 25bp at the release of the June Monetary Policy Statement. But we believe it is a very tight call between cutting at this MPS or waiting until August to reassess,” says Nick Tuffley, ASB Chief Economist, in Auckland.

ASB reckon soft inflation will continue to be a major worry for the RBNZ and this should guide their hand.

All up we judge that events since both the March and April OCR decisions point to slightly weaker inflation pressures than the RBNZ has anticipated.

There is one major constraint to cutting rates though and that is New Zealand’s house prices are looking overpriced there is a danger any cuts could fuel the bubble as it would make mortgage lending cheaper.

Tuffley believes the RBNZ will likely ignore the housing issue though; “the RBNZ may be concerned about the impact on the housing market of further near-term OCR cuts, given that any macro-prudential action on housing is months away. But we are unconvinced that there are clear benefits to be gained from waiting further if the underlying economic case for an OCR cut remains.”

However, analysts at Nomura disagree and say housing will trump all in the June decision:

"Although we think the decision will be a close call, we believe that, ultimately, concerns about renewed strength in the housing market and decent domestic data will matter more than the weakness in inflation and inflation expectations, and the strength of NZD and that the RBNZ will leave its policy rate unchanged."

The consensus agrees with 7 out of 15 economists expecting rates on hold and futures markets are only pricing about 8bp ahead of the event.

"This means that, if the RBNZ keeps rates on hold but continues to signal openness on cutting later this year, the impact on the currency is likely to be small. However, if it decides to surprise and cut, NZD would likely depreciate meaningfully, given its recent strength and positioning," says Charles St-Arnaud at Nomura.

One reason to believe the RBNZ could opt to cut rates is that dairy prices are not getting the expected upside traction the central bank would like.

NZ dairy cooperative Fonterra's forecast for the 2016-17 milk payout is NZD4.25/kg, this might be up on the $3.90 level for this year, but was below the $4.60-4.80 expected and is well down on the 2013-14 peak of $8.90.

Dairy is New Zealand’s main export and the RBNZ will do what it can to help keep this important source of income propped up, and cutting rates and lowering the NZ dollar by proxy is certainly one means by which this aim can be achieved.

“It remains an imperative for the central bank to keep downward pressure on the NZD and avert another leg lower in inflation expectations in our view,” says Tony Morris at Bank of America Merrill Lynch Global Research.

NZ$ to be Targeted?

Even if the RBNZ fails to cut, expect it to take aim at the strength of the NZD.

The exchange rate will feature heavily in the RBNZ's deliberations and Bank of America believe it is possible the substantial 4.4% improvement in terms-of-trade in 1Q will increase their tolerance for a stronger trade weighted index.

“However, we believe the RBNZ will be extremely wary of any communication that leads to a further appreciation in the exchange rate from here. This suggests it will maintain its view that the NZD "remains higher than appropriate", as well as keeps its easing bias irrespective of whether it cuts the OCR or not,” says Morris.

Selling the Kiwi

We would urge caution on backing a higher NZD this week - we have learnt that the RBNZ cares little for consensus, in fact, if anything, they know that to achieve their aims a surprise is the best way to do so.

The March cut, a surprise to many, is proof.

Therefore, if inflation is the ultimate target a cut is a strong possibility and a slump in the NZD is on the cards.

Some big-name strategists are already betting on a weaker New Zealand dollar on this basis.

"We expect NZD to weaken against its peers. as markets have not fully priced in further easing at the next RBNZ meeting," say Barclays.

Both Morgan Stanley and Barclays have this week advocated a sell on the NZD vs the JPY. The thinking is not hard to see - where New Zealand has the highest basic interest rate, Japan has the lowest.

It costs money to save money in Japan.

Therefore the flow of borrowed JPY into NZD is one of the foundations of the 'carry trade' - the trade where cheap money is invested into high yielding areas.

How long NZD retains its high-yield advantage will be seen mid-week.