Roger J Kerr says the Australia-US exchange rate is likely to surge higher faster and further than the NZ dollar-US dollar rate over coming months

Summary of key points: -

• Short-term NZD direction dependent upon RBNZ and US PCE inflation
• Medium-term NZD direction dependent upon the fortunes of the Aussie dollar

Short-term NZD direction dependent upon RBNZ and US PCE inflation

There is much anticipation ahead of this Wednesday’s Reserve Bank of New Zealand (“RBNZ”) monetary policy statement. Not only because the RBNZ has not reported on the economy/monetary settings for an age since last November, but also because there is dividend opinion as to whether the economy has been more resilient than the RBNZ expected back in November and therefore the OCR interest rate has to be hiked again.

It could not be argued that the economy has been stronger than RBNZ expectations, lower activity levels and trading difficulties in retail and building sectors tell you this. A much more forceful argument is that higher interest rates from the current 5.50% setting would make no difference to the sources of the ongoing high level of non-tradable (domestic) inflation. The inflation is from the supply side of the economy, the public sector and non-competitive industries who just keep putting their prices up on households and are insensitive to interest rates. Higher interest rates from here would send the economy into deeper recession and hurt household too much, for no ultimate benefit of lower inflation.

The counter argument to no further interest rate hikes, is that the RBNZ have witnessed inflation being outside their 1.00% to 3.00% target band for over 18 months now and therefore they have totally failed their inflation control remit. They only have one mechanism to get inflation down and that is hammering down demand in the economy through higher interest rates. They clearly need interest rates well above other countries so that the NZ dollar appreciates, forcing tradable/imported inflation to zero to offset the permanent 4.00% non-tradable inflation. As discussed in last week’s column, up until now the US have increased interest rates by the same amount as New Zealand, therefore not allowing the normal Kiwi dollar appreciation. The Federal Reserve is now likely to commence cutting their interest rates in May, so that situation has changed dramatically. The RBNZ is now more likely to get a bigger “bang for their buck” in shoving the OCR higher to reduce inflation (through the currency transmission method).

If the RBNZ does not hike the 5.50% OCR on Wednesday, their statement will have to be overtly hawkish to attempt to change the price-setting behaviour in sections of the economy discussed above. Either way, it appears to be an event that will fuel independent NZ dollar strength, as FX traders and investors recognise the diverging paths between the US and NZ on monetary policy.

A greater influence on the NZD/USD exchange rate this week could well come two days later from the US PCE inflation figures for January being released on Thursday night (NZT). An inflation increase of 0.20% for the month will pull the annual headline inflation rate down from 2.60% to 2.30% - very close to the Fed’s target of 2.00%. Over recent weeks, the sentiment in US interest rate markets and the FX markets has been that stronger than forecast economic data will delay the timing of Fed cuts. The probability of the first cut in May has reduced from 60% to 30%. However, not all the data has printed on the stronger than forecast side. Retail sales for January were very weak and many economic commentators regard the stronger December and January jobs numbers as spurious, therefore inaccurate data. Durable goods orders figures on Wednesday night also appear to be very soft.

FX market sentiment towards the US dollar may change abruptly as inflation and other forward- looking data confirms a low level of risk of inflation igniting again, and that in turn provides more confidence to the Fed to cut interest rates.  

Medium-term NZD direction dependent upon the fortunes of the Aussie dollar

It is not unreasonable that New Zealanders view their trans-Tasman cousins as somewhat more bold, brazen and confident than our more laid-back characteristics. The natural larrikin/gambling traits and instincts of the Aussies is seen in their business giants such as Rupert Murdoch and the late Kerry Packer. There are many more examples of Australian business and economic success through an in-built confidence to take on the world and “go large!”. It was recently reported that Macquarie Bank’s top commodities trader/investor, Nick O’Kane was retiring and that his personal income in recent years was above that of the CEO’s of Wall Street investment banks such as JP Morgan and Goldman Sachs. Leadership and vision 50 years ago, from Australian politicians at the time, established the compulsory pension deductions from salaries and therefore the creation of the massive Aussie superannuation investment funds we see today, only rivalled by Norway in size on a per-capita basis.

The Australian economy and the Aussie dollar are typically viewed as riding along the boom/bust cycles of their mining industry. Over the last 20 years their GDP growth has been inextricably linked to Chinese demand for their iron ore, coal, gas and other metals. The “lucky country” living off the back of high mining prices produced increased incomes and wealth through the 1990’s and in the 2000’s up until 2014. However, over the last decade the Aussie dream has lost some of its lustre as commodity prices dropped and global investment funds preferred assets elsewhere in the world. A downturn in building new mines has certainly been a negative for the Australian economy in this respect.

Australia is typically viewed as a market of big opportunities and associated risks. An example of risk exceeding opportunity lately has been the closure of lithium and nickel mines in Australia as demand was over-estimated and over-production/excess inventory has driven these mining prices lower. The big question now in mining circles in Australia is whether iron ore goes the same way as lithium and nickel?

On the opportunities side, you have to hand it to the Aussies for cashing-in on “Swiftonomics” as manic demand for Taylor Swift music concerts over recent weekends in Melbourne and Sydney has added over AUD1 billion to the Australian economy. New Zealand did not get a concert because pathetic Nimbyism and bureaucracy prevented Eden Park being available. In New Zealand we are very good at finding ways not to do something!

Economic trends in Australia are broadly positive for GDP growth this year above 2.00%. GDP number for the December 2023 quarter are released on Wednesday 6th March and will be over 2.00%. Whilst recent retail sales and jobs data have been on the weaker side, the Reserve Bank of Australia (“RBA”) would have to be concerned at recent wage increases running at 4.20% per annum. The RBA concern is that the continuing high wage increase are not being match by an improvement in productivity, therefore it is inflationary. For this reason, the RBA (like the RBNZ) will not be reducing interest rates in 2024. The next RBA meeting on monetary policy/interest rates is 19th March.

With the Fed and RBA now also diverging on monetary policy, Australia will have the opportunity to drive their tradable inflation down with a higher Aussie dollar value to offset their sticky +4.00% non-tradable inflation. Australian two-year swap interest rates are likely to stay above 4.00% this year, whereas US two-year swap interest rates are poised to decline from their current 4.80% to 4.00%. As Australin and US short-term interest rates converge together, the attraction of short-selling the AUD against the USD by currency speculators will be eroded away. Unwinding of short-sold AUD speculative positions still stands as a major positive for the Aussie dollar. History tells us that when Australian interest rates move up from below US interest rates to equal US interest rates, the AUD/USD rate appreciates to well above 0.7000 (currently 0.6570).

The conclusion from examining Australia’s economic and business outlook is that the Aussie dollar is set to come back in favour with global investors after being out of favour with China concerns for so long. Investment bank, UBS which has one the largest funds management and private wealth operations in the world, recently indicated that they would be increasing weightings of investment assets into the Australian dollar as they see it as undervalued.

The chart below depicts the three AUD plunges (and subsequent rebounds) in value since 2014. The current plunge (Plunge 4 on the chart) has displayed a triple bottom at 0.6500 as the global FX markets wax and wane on Fed interest rate cuts. Another strong rebound upwards from the bottom has to be on the cards as more players recognise how much the AUD is undervalued.

The AUD/USD exchange rate is likely to surge higher faster and further than the NZD/USD rate over coming months, dragging the NZD/USD upwards, however forcing the current 0.9450 NZD/AUD cross-rate back down.  

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