Roger J Kerr says the fundamental premise of lower US inflation, equals lower US interest rates, equals a lower US dollar still holds as compelling today as it was in early 2023

Summary of key points: -

• US dollar depreciation finally arrives – six months later than expected!
• RBNZ reforms on the way
• Economic reinvigoration under the new government?

US dollar depreciation finally arrives – six months later than expected

A reflection back on the last twelve months of foreign exchange market analysis, commentary and forecasts leaves one concluding that the US dollar deprecation confidently expected by mid-year, has finally arrived towards the end of the year. “Timing is everything”, as they say.

Our outlook at the start of 2023 was that the US Federal Reserve would have sufficient evidence of lower inflation and weaker demand in the economy by mid-year to pause and pivot on their monetary tightening cycle. Those changing circumstances would propel the US dollar downwards against major currencies as US interest rates declined.

Our timing may have been out by six months, however the fundamental premise of lower US inflation, equals lower US interest rates, equals a lower US dollar still holds as compelling today as it was in early 2023. The six month delay around the forecast for the NZ dollar to appreciate (on a weaker US dollar) to transpire into reality may be summarised as being caused by four inter-related developments: -

• The US economy, in particular the labour market, remained robust through from January to July, which prevented the Fed from moving away form its “higher for longer” interest rate mantra. As a consequence of the strong employment conditions, US consumers continued to spend the last of the Covid helicopter money from the Government over the May to August summer months. The increase in oil and gasoline prices in September raised some Fed concerns about inflation re-igniting again.
• The September increased “dot-plot” interest rate forecasts by individual Fed members caused some shivers in the financial markets at the time. The markets were anticipating that the Fed members would keep their 2024 interest rate forecasts below 5.00%, however most lifted their forecasts to above 5.00%. Were they seeing some new inflation threats that everyone else was not seeing? The USD strengthened after the higher “dot-plot” forecasts.
• The delay in the US Government debt ceiling agreement until July meant that large amounts of new debt issuance (Treasury Bonds) were compressed into the September and December quarters as new debt could not be issued for several months beforehand. As we have previously highlighted, the absence of foreign investors from the bond market caused a situation of bond supply dramatically exceeding demand. The net result was sharply lower bond prices and higher bond yields. The US dollar strengthened from July though to September on the higher bond yields.
• The Reserve Bank of Australia inexcusably took an ill-advised six month holiday (from May until November) from tightening monetary policy with interest rate hikes to combat their high inflation. Thankfully, the change of RBA Governor from Philip Lowe to Michelle Bullock has retuned some common-sense and urgency to the management of monetary policy. Their inflation problem is homegrown with wages, energy prices and rents increasing. Only higher interest rates will change price setting behaviour in these areas. The Aussie dollar remained very much out of favour (until now) with global investors and currency traders as their interest rates remained 1.00% below that of the US interest rates.

Over recent weeks, for a variety of reasons a paradigm shift has occurred with all four of the above factors effectively reversing in direction, intensity and influence on the US dollar value: -

• US inflation, employment, housing and consumer economic data has all printed on the softer side of prior forecasts. The Fed can finally relax somewhat, and the rhetoric has started to change with a swag of evidence that the US annual inflation rate currently at 3.20% is headed well into the 2.00% arena over coming months. Household spending is weaker with listed retail companies such as Lowes reporting lower profits and weaker forward guidance. Oil prices have reversed from US$95/barrel to US$76/barrel. As a result, the US dollar has weakened back.
• We will get to see the newly updated “dot-plot” interest rate forecasts from the Fed’s members at the 13 December Fed FOMC meeting. There does not seem to be any accountability or consequences for the September forecasts being so inaccurate, however the new forecasts for 2024 will be revised to below 5.00% again i.e. US dollar negative.  
• US 10-year bond yields have reversed engines from 5.00% a month ago to 4.45% as the volume of new longer dated bonds being issued is revised lower than earlier estimates. The supply/demand equation for bonds has now been put into better balance. The US dollar is already following the bond yields lower (depreciating from 107.00 on the Dixy Index to 103.30), allowing the NZD/USD rate to post further gains. Further reductions in the bond yields to 4.00% by Christmas seem likely as all the short-sold speculative bets, put on a few months ago, are closed-down.
• The RBA are unlikely to lift their OCR interest rates at their December meeting, however there is a more than 50% probability that they will increase by 0.25% to 4.60% at their February meeting. Therefore, expect further AUD appreciation against the USD from 0.6600 to above 0.7000 as the new interest differential environment (lower US interest rates, higher Aussie interest rates) renders the Aussie dollar a whole lot more attractive to buy and hold.

In trading higher to near 0.6100, the NZD/USD exchange rate is not far away from breaking above its downtrend line that has held firm since 2021 (intersection is at 0.6200).  

RBNZ reforms on the way

In their election campaign the National Party pledged to make changes with the Reserve Bank of New Zealand’s (“RBNZ”) remit on managing monetary policy. Messrs Peters and Seymour concur on this matter; therefore the coalition deal will see the RBNZ’s mandate revert to a single focus of controlling inflation, the employment and housing objectives introduced by the previous Government being dumped. Let’s hope they go further and not just revert to a single inflation objective, however, also change back to monetary policy decision making being in the hands of a single person, the Governor Adrian Orr. It cannot be said that bringing in three external academics into the monetary policy committee has been a great success with more robust analysis, interpretation and decision-making. The three external members of the committee appear to have agreed with every piece of RBNZ analysis put forward and have not questioned or dissented on anything. Interestingly, the RBA in its reforms is moving to a new monetary policy committee with a majority of external members.

Quite rightly, new Finance Minister, Nicola Willis wants Adrian to be personally on the spike for all monetary policy decisions made by the RBNZ. Adrian’s first decision under his new masters will be this Wednesday 29th November where he will be contemplating telling the interest rate markets that they have “become too far ahead of themselves” in pricing OCR cuts by mid-2024. The fight against our high, sticky, wage-push inflation is not over yet and the RBNZ have no reason to move away from their current stance of holding OCR interest rates at the current 5.50% for all of 2024. Only the economy diving into deep recession would allow earlier interest rate cuts, and a recession does not seem likely.

It would also be refreshing to hear the RBNZ explain some cold hard truths that the inflation problem we have today is largely due to the previous Government’s immigration policies (causing chronic labour shortages and spiralling wages) and housing policies (removing interest deductibility and therefore rental properties were sold to owner-occupiers, causing rents to spiral higher as a result of the lower supply of rental properties). The RBNZ should be in their element describing these economic cause and effect impacts!

There is no reason for the RBNZ to change their current stringent stance on getting inflation down, therefore this week’s monetary policy statement should be positive for the Kiwi dollar.

Economic reinvigoration under the new government?

The stupendous increase in business confidence over recent months (from -70 to +20 on the survey index) tells us that the business community have very high expectations that the economy will get a boost in 2024 from the change in government. No pressure, Christopher and Nicola!

There is certainly a feeling of a fresh start and reinvigoration under a wave of more business-friendly policies on industrial relations, infrastructure, reduced regulation, lower income taxes and fiscal restraint. Whilst the Government can play a key role in assisting an even playing field for business, how the NZ economy performs always comes back to the export commodity price and residential property price cycles. Hopefully, we have moved on from the boom/bust mentality in both these major economic drivers.

The local sharemarket has been in the doldrums over the last three years with no foreign portfolio investor interest and no attractive IPO’s coming to the market. Looking ahead, that soft performance may change for the better with global investment funds adjusting USD asset weightings lower and therefore scouring the world for undervalued share markets and undervalued currencies. New Zealand fits that criteria for both rather nicely.

As we have previously highlighted in this column, the NZD/USD exchange rate has a close historical correlation with NZ business confidence. The current level of business confidence suggests an NZD/USD exchange rate appreciation to well above 0.7500. Such a large gain may be a stretch; however it certainly does not point to the Kiwi dollar depreciating below 0.6000 again. How far the NZD/USD rate climbs into the mid-0.6000’s over coming months will be determined by USD movements offshore. Our view remains unchanged of a weaker US dollar ahead for the reasons cited in the first section above.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.