NZ dollar world's strongest last week, but focus on Bank of Japan and reaction to horror quake and tsunami

 

By Mike Jones

 

Against all the odds, the NZD/USD was the strongest performing G10 currency last week.

 

Sure, the RBNZ slashed rates 50bps, more than most economic forecasters expected (including us). However, the Bank was quick to point out that the reduction was an ‘insurance’ cut only, and would be removed as soon as matters Christchurch settled down. Reinforcing this notion was the Governor’s post MPS comments that the OCR is unlikely to be cut again.

 

And so, after a quick knee-jerk decline to around 0.7330, the NZD/USD soon stabilised around 0.7350 on Thursday as investors factored in a slightly faster pace of RBNZ tightening over the next 12 months (around 40bps worth).

 

On Friday, the NZD/USD marched higher, reflecting a bout of broad-based USD weakness. Heavy USD/JPY selling triggered the move after the devastating Japanese earthquake and tsunami prompted speculation Japanese insurers will repatriate JPY to pay damage claims. The AUD, EUR and NZD all surged over a cent against the retreating USD, such that the NZD/USD finished the week at a one week high of around 0.7430.

 

A bout of short position squaring also helped insulate the NZD from a mild deterioration in risk appetite last week (our risk appetite index fell from 66.2% to 62.4% over the week). This was most notable relative to the AUD, which was knocked back by last week’s surprise Chinese trade deficit. After slumping to 19-year lows around 0.7250 last Monday, NZD/AUD finished the week around 0.7330.

 

Looking ahead, in a comparatively light NZ data schedule, Wednesday’s Fonterra auction will see milk prices remain relatively buoyant, albeit vulnerable to a modest correction. Meanwhile, this week’s consumer sentiment indices will surely struggle in the wake of the Christchurch earthquake.

 

Overall, we suspect gyrations in global risk appetite will dictate the fortunes of the NZD this week. Important influences in this regard will be the Japanese government’s response to the weekend’s devastating tsunami (the Bank of Japan meet this afternoon), Wednesday morning’s FOMC policy announcement, a slew of US data, and investors’ response to the weekend’s announcement from European leaders that they will widen the scope of the European sovereign rescue fund.

 

Currently, “fair-value” in NZD/USD, according to our short-term valuation model, is sitting at 0.7100-0.7300. A 5 percentage point increase in our risk appetite index would be consistent with “fair-value” moving up to 0.7200-0.7400. In the near-term, solid support on NZD/USD is eyed towards 0.7325. Initial resistance is seen at 0.7550.

 

Majors

The USD weakened against all of the major currencies on Friday night, most notably the JPY.

 

News Japan had suffered the worst earthquake in 140 years, along with a vicious tsunami, rattled financial market sentiment on Friday, causing significant volatility across most asset classes. Investors’ immediate response was to sell the JPY along with ‘risky’ or high yielding assets.

 

USD/JPY briefly lurched to two week highs above 83.20, European equity indices tumbled 0.3-1.2% (the EuroStoxx 50 fell 0.9%) and commodity prices gave up some of their recent gains as folk factored in weaker Japanese demand. Japanese equity futures fell 3.3%.

 

However, these moves were later more than reversed as investors reassessed the likely fallout from the catastrophe. Most notably, the JPY rallied aggressively amid market chatter Japanese insurance firms will have to repatriate JPY funds to pay damage claims. Such was the experience following the Great Hanshin Earthquake of 1995.

 

From around 83.20, USD/JPY skidded back below 82.00, with heavy selling of JPY crosses also contributing to broad JPY strength. The extent of USD/JPY selling soon saw most of the major currencies tracking higher against the USD, helped by a broad recovery in risk appetite. Indeed, European equity indices pared earlier losses and US equities actually managed to post modest gains. The S&P500 rose 0.7%, to end the week down 1.3%. From around 22%, the VIX index (a rough proxy for risk aversion) dribbled off to around 20%.

 

Against the broadly weaker USD, the AUD/USD climbed from below 1.000 to nearly 1.0150 and the EUR/USD surged over 1c to around 1.3900. Helping bolster EUR sentiment, Portugal announced additional spending cuts to curb its deficit and European leaders reached a tentative agreement on a competitiveness pact at the EU summit.

 

Looking ahead, market focus is likely to remain on Japan this week, in particular the extent of damage caused by the Tsunami and the shape of the government response. It’s worth noting in this regard that the BoJ has brought forward its policy decision to today, with investors also on the lookout for a possible emergency budget from the Japanese government.

 

Should officials opt for an all guns blazing response to the tragedy (likely involving more quantitative easing from the BoJ and the government issuing more debt) we’d expect to see USD/JPY start to grind higher again this week. Aside from the Japanese response, there is plenty of other event risk to watch for this week including the latest FOMC decision, the RBA’s Board minutes, and US inflation and housing figures.