Roger J Kerr says it has just taken an extraordinary length of time for the Fed and the markets to conclude that interest rates did not need to go any higher and would need to come down in 2024 to avoid a recession

Summary of key points: -

• How the Fed pivot on monetary policy came about
• How does the NZ economy extricate itself from the debilitating stagflation?

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How the Fed pivot on monetary policy came about

In last week’s column we led with the headline “US markets price-in victory on inflation – it just needs the Fed to confirm”. We did not anticipate that the Fed would confirm a pivot on monetary policy so soon.

However, last week’s Fed meeting certainly turbocharged a slide in interest rates and the US dollar value that will go down in financial market history as the largest ever climb-down on setting monetary policy. The Fed revised down both their GDP growth and inflation forecasts for the US economy, sending 10-year Treasury Bond yields sharply lower again from 4.24% to 3.91% and the US dollar spiraling lower from 104.00 on the Dixy Index to a low of 101.50 (a 2.40% decline on the day). The Fed no longer see risks of inflation rearing up again and are now more comfortable that a softening labour market is not going to cause upward wage and price pressures.

Central banks like the US Federal Reserve often observe and criticise the “reef-fish” like skittish behaviour of financial markets causing volatile movements up and down for no fundamental rhyme or reason. In a review of their own behaviour in 2023, the august members of Fed may ponder how the abrupt and unfathomable changes in their own interest rates forecasts caused more financial market volatility than was necessary. A simple review of their “dot-plot” interest rate forecasts from June, September and December confirms that the Fed members themselves are as skittish and inconsistent as the market reef fish. Not that much changed with the trends of inflation, employment, housing, consumer spending and manufacturing in the US economy from September to December to cause such a sudden U-turn in viewpoint and outlook. Maybe the lower interest rate forecasts in the December dot-plot was the admission that their higher September interest rate forecasts were horribly wrong. There have been many forward indicators for inflation and jobs in the US economy since June that have pointed to a continuation of the steep downtrend in inflation and a softening of the labour market conditions. It has just taken an extraordinary length of time for the Fed and the markets to conclude that interest rates did not need to go any higher and would need to come down in 2024 to avoid a recession.

What it means for the NZD/USD exchange rate value: -

• US interest rates are cut earlier and by more in 2024 than New Zealand interest rates.
• The widening interest rate differential to over 1.00% should attract “carry-trade” funds into the Kiwi dollar, particularly if the Australian/US interest rate differential also widens, causing the undervalued AUD to appreciate (NZD following).
• Further falls in US inflation and interest rates are likely to depreciate the US dollar back to 95.00 on the Dixy Index, where it stood before the increase in inflation and interest rates commenced in 2021. A USD Index at 95.00 is equivalent to an NZD/USD exchange rate of 0.6800.
• Global funds reducing their USD weightings will seek out alternative currencies to invest into. The Euro does not seem that attractive given Europe’s weak economic growth, therefore the Antipodean currencies might stand out as both undervalued and a long way from global trouble-spots.
• Speculative currency positioning (as measured by the CFTC) saw long USD Index positions being pegged back to 17,600 contracts over recent weeks. Long USD positions peaked at 45,000 contracts in mid-2022, however further unwinding of positions (USD selling) is likely to see long USD contracts decline right back to zero - where they were in mid-2021.
• US investment fund flows are already flooding back into Emerging Market ETF’s (bonds and equities) as those economies benefits from lower US interest rates and higher export commodity prices in local currency terms. The Kiwi and Aussie dollars always benefit when Emerging Markets as an investment asset class moves higher.

How does the NZ economy extricate itself from the debilitating stagflation?

We know how the New Zealand economy got into this stagflation predicament, but are we collectively smart enough to extract ourselves out of it?

The current Minister of Finance, Nicola Willis is honest and upfront with a reality check about the challenges the NZ economy faces. It is a refreshing change from the cynical economic gobbledygook the previous Minister, Grant Robertson attempted to hoodwink the NZ public with. Both employers and employees should also realise that the Government cannot perform economic miracles to turn this economy around. Cutting your cloth to the reality of today’s situation equally applies to business and workers, as it does to the Government and the public sector.

Business confidence has improved dramatically over recent months, however that will only convert into improved GDP growth if businesses invest and expand. The confidence to do that will have to come from a number of fronts: -

• Certainty of Government tax and fiscal policies. Maybe some investment incentives (depreciation write-offs) are needed to push the investment along.
• Lower long-term interest rates that allow investment returns to lift above lower WACC hurdles, and thus allow new investment decisions to be made. NZ risk-free bond yields are following US bond yields lower.
• Global demand picking up for the export sector. Lower US interest rates certainly help with this.

Other things the new Government can do to reduce inflation and increase economic growth may be summarised as follows: -

• Fiscal austerity policies to reduce deficits, inflation and wasteful spending.
• Slashing regulatory red-tape that strangles development and progress in the NZ economy.
• Refreshed energy into free-trade agreements with India and an expanded CPTPP from the current 12 members in the Pacific (e.g. the US).
• Major reforms in the local government sector – forcing Council amalgamations to reduce a massive duplication of overhead costs. Reducing central government imposed regulatory costs on local government.
• Contracting long-term with the private sector and offshore parties to actually build new infrastructure projects, rather than just talking about it.
• Government incentives to promote worker training in the tourism sector.
• Introduce an “Inflation Responsibility Bill” to sit alongside the Fiscal Responsibility legislation to ensure all Government laws and regulations are put through a compulsory checking lens that inflation is not increased as a result. The RBNZ should be advocating such changes to control inflation in New Zealand, unfortunately they are always at the bottom of the cliff, rather than applying preventative risk management on inflation at the top of the cliff.

The Luxon Government is already on the case with some of these initiatives, however they need to move quickly to assist in getting the economy back on track. Last week’s backward-looking negative GDP numbers for the September quarter will be largely ignored by forward-looking FX markets and will not hold back further NZD appreciation above 0.6200 in a weaker USD environment.

What lies ahead in 2024 is what the forex markets focus on, and we now have more certainty that US interest rates and the US dollar will continue to trend lower.

The most compelling currency chart that points to significant NZD appreciation over coming months is the AUD/USD exchange rate (which the NZD/USD rate follows) plotted against the interest rate differential between Australia and the US. Further falls in the US 2-year swap interest rate from its current 4.25% level to below 4.00% will lift the differential from the current -0.10% to +0.25% and lift the AUD with it.

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