By Danica Hampton

NZD/USD climbed markedly last week, from below 0.6900 to just under 0.7100 "“ its highest level in 13 months.

Much of the recent strength in NZD/USD is attributable to broad-based USD weakness. Worries that Asian central banks may step-up the pace of reserve diversification and a decline in US bond yields saw the USD slide sharply last week. Improving Chinese data and solid risk appetite (our risk appetite index rise above its average of 50% for the first time in a year) also encouraged demand for growth sensitive currencies like NZD and helped weigh on the USD.

While most currencies climbed against the USD last week, the NZD had the dubious honour of being the strongest performing currency. The RBNZ left the OCR unchanged at 2.5% last week and reiterated its now long-held view that it expects "to keep the OCR at or below the current level through until the latter part of 2010". However, the market reaction suggested investors don't believe the RBNZ will be able to hold its line for as long as it suggests. Market pricing is still consistent with the first tightening coming in March (in contrast, our economists look for the first rate hike in July).

Undeniably, NZ fundamentals have improved over recent months. Not only is risk appetite now sitting around its long-term average, but NZ-US interest rate spreads have widened and NZ commodity prices have recovered. Our short-term valuation model (which is based on NZ-US interest rate spreads, NZ commodity prices and risk appetite) suggests a "˜fair value' range for the NZD/USD of 0.6850-0.7050.

However, NZD/USD looks at risk of getting over extended and this suggests that bounces above 0.7050 are unlikely to be sustained (this is further reinforced by the downside risks we see on to NZ-US interest rate spreads due to our less hawkish view of RBNZ policy).

With the global economy emerging from recession, and the NZ economy poised for a gradual recovery, we expect the NZD/USD to gradually trend higher over the coming year. That said, we can't help but think the NZD has got a bit ahead of itself and a correction may be in order in coming weeks. However, if USD sentiment remains negative and risk appetite solid, we may well see further NZD/USD gains first.

Some headwinds are expected ahead of 0.7090-0.7100, but a push towards 0.7150-0.7200 is possible if the USD continues to march lower this week. Initial support is expected ahead of 0.6990-0.7000.

The USD weakened against most major currencies on Friday night, continuing the theme that prevailed over the past week. On a trade-weighted-basis, the USD Index finished the week down nearly 2%.

Concerns that China and other Asian central banks were stepping up their efforts to diversify out of USD assets weighed heavily on the USD. The steady decline in US bond yields did little to help USD sentiment (US 10-year bond yields fell 9bps to 3.347% last week). The drop in US interest rates has encouraged many "carry trade" investors (those whose borrow in a relatively low yielding currency and invest in a relatively high yielding currency) to use the USD as the funding currency.

Against a generally weaker USD, EUR/USD broke above 1.4450 early last week and climbed to above 1.4600. However, JPY and CHF were the stand-out performers. USD/JPY fell nearly 3% from above 93.00 to below 90.50. Market commentators suggest the JPY strength was driven by Japanese investors hedging their exposures to hybrid option products following the drop in US yields.

USD/CHF fell about 2% from 1.060 to below 1.035 as investors tested the Swiss National Bank's resolve to keep the currency weak. There were rumours of SNB intervention last Thursday (in both USD/CHF and EUR/CHF) and markets will pay close attention to this week's SNB meeting for a gauge of the central bank's commitment to preventing further CHF strength.

This week's US data should help determine whether US interest rates will continue to slide lower and whether the September rebound in equity markets can persist. The data to watch includes Tuesday's retail sales, Wednesday's CPI and industrial production and Thursday's building permits and Philadelphia Fed Index. We suspect it will be a case of watching US interest rates to see whether or not the downward momentum in the USD will continue this week. If the US data is grim "“ not only will it likely push US 10-year government bond yields down towards 3.0%, but it will also likely take a toll on Wall Street. Such a scenario would likely put heavy downward pressure on USD/JPY.

It's worth noting, officials worldwide do not generally want a dramatically weaker USD. Not only will a weakening USD erode the value of China's and Japan's holdings of US government bonds, but weekend media reports highlights the financial stability risks associated with sharply weaker USD. We do not expect the USD weakness to continue at the same pace over the coming months, but it may continue in the near-term. On the USD Index, next support is eyed in 75.90-76.00 region.

* Danica Hampton is BNZ's Senior Currency Strategist. All of the research produced by the BNZ Capital team of economists is available here.