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New Zealand Dollar to Recover Against Euro in 2018 say RBC Capital

Finding places where political risk and monetary policy expectations have either undershot, or overshot, expectations is key to winning trades for the year ahead.

The Euro is tipped to give back much of the ground it has gained over the New Zealand Dollar in the coming year, suggest strategists at RBC Capital Markets; a call based on expectations for a gradual shift to a 'more normal' interest rate environment, amid continued low inflation and ever-present political risk.

Looking for places where political risk and monetary policy expectations have either undershot, or overshot, expectations is key to finding winning trades for the year ahead according to the RBC FX team.

And the idea that the New Zealand Dollar's recent decline in response to the change in government is overdone reflects this view.

“Our first trade for 2018 is short EUR/NZD,” says Adam Cole, chief currency strategist at RBC Capital Markets. “We look for its gains to fully reverse in 2017 driven by relative rate dynamics, political risk but also outright yield.”

Current price levels of EUR/NZD, which make it the best performing pair of G10 currencies for 2017, mean it is a prime target for short-sellers.

“Euro outperformance has been driven by the unwind of its political risk premium, while NZD has seen the reverse,” says Cole.

Strong Eurozone economic data and expectations of a turning point in European Central Bank monetary policy helped propel the Euro to the top of the G10 basket in 2017.

The New Zealand Dollar, on the other hand, has been hit by the outcome of September’s election which has ushered in a coalition government that wants to reform the Reserve Bank of New Zealand and push ahead with a host of other policies markets are concerned about.

New Zealand’s currency has fallen 6% against the US Dollar over the six weeks since the outcome of the election became known and is down more than 13% against the Euro for the year to date.

Above: EUR/NZD shown at daily intervals. Captures second half of 2017.

“We think EUR/NZD is mispriced on both counts,” says Cole. “The risks around the EUR’s political risk premium are now asymmetric, given there is next to nothing left to unprice, while NZD’s political risk premium is high even though many of the new government’s policies are likely to be inflationary and would all else equal lead to tighter monetary policy.”

Economists are concerned about the Labour-led coalition’s proposed clamp-down on inbound migration, which could mean a 40% fall in net-migration, given its potential to impact on growth over the longer term.

A dual mandate for the RBNZ, requiring it to target full employment alongside inflation, has also seen the outlook for NZ monetary policy become more uncertain and has hit the NZ Dollar.

“There has been a lot of focus on the proposed review of the RBNZ’s mandate but across G10 FX, central banks with a single or dual mandate have very similar reaction functions, and when estimating their sensitivity to inflation and employment gaps, the results are remarkably similar,” says Cole.

It’s frequently noted, but often overlooked in the discussion around the RBNZ mandate, that the NZ economy is already operating close to full-capacity and the 4.6% rate of unemployment probably means the economy is quite close to full employment.

Above: EUR/NZD at weekly intervals. Captures trading since Jan 2015 announcement of ECB QE.

Lower net migration and higher employment could mean inflation begins to rise faster in New Zealand than it does elsewhere during the coming year which, more than anything else, would bring forward the time at which markets estimate an interest rate rise becomes likely. This would be supportive of the New Zealand Dollar.

“Both regions have seen economic slack eroded (unemployment is at or through estimates of NAIRU in both cases) but underemployment is significantly higher in the Euro area than it is in New Zealand, suggesting it will take considerably longer until we see sustainable inflation in the Euro area,” says Cole.

The RBC team recommend holding short positions in the EUR/NZD pair throughout 2018 in order to benefit from downside in the exchange rate, as well as nearly 300 basis points of “carry” interest which accrues due to the interest rate differential between NZ and Europe.

There is no stop loss or target price with this trade as its is a thematic idea for the duration of 2018. RBC Capital Markets forecast EUR/NZD will finish the 2018 year at 1.6200, which is a full ten cents below the 1.7274 level it was quoted at Friday.

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