Westpac's economists says the Kiwi dollar will stand above the crowd for a while yet, but in the end it will start edging lower

By the Westpac NZ economists*

The New Zealand dollar continues to linger above 70 cents against the US dollar, propped up by the surge in dairy prices and solid momentum in the New Zealand economy.

While robust growth will keep the Kiwi well supported in coming months, its allure will begin to fade next year as the US Fed continues with gradual policy tightening.

The Kiwi is expected to come under further pressure heading into 2018, as growth in New Zealand begins to slow.

The Kiwi regained its wings earlier in the year, and has lingered above 70 cents against the US dollar since our August Economic Overview. This solid performance has been despite the Reserve Bank reducing the OCR to a new record low of 1.75% in November. Lower rates have been countered by other developments, including the 50% rise in global dairy prices, and strengthening momentum in economic activity more broadly. Local interest rate markets have now taken the chance of a rate cut in 2017 off the table, and instead are itching to price RBNZ rate hikes in.

While we think the possibility of a rate hike in 2017 is slim given low inflation, the outlook for growth is much rosier than it was a few months back. But the same can’t be said for other countries, with the global growth backdrop remaining decidedly lacklustre.

So with New Zealand’s growth and interest rates expected to stand above the crowd for a little longer yet, the NZ dollar will continue to be well supported. Notwithstanding a sustained “risk-off” event, we’re expecting the NZD/USD to linger around 70 cents for much of next year, before heading down toward the mid-60 cent level in 2018.

Of course, much depends on how things play out on the US side of the coin. The NZD/USD has been kept at bay over the past few months by a strengthening US dollar, as markets become increasingly convinced about Fed rate hikes over the next year. Firming sentiment reflects a pickup in US growth and rising inflation, while the unexpected US election result, and the potential boost to growth from increased infrastructure spending and tax cuts, have pushed interest rates and the US dollar higher still.

We’re expecting the Fed to raise rates in December, followed by two hikes in 2017. Higher US rates, while New Zealand’s policy rate is expected to remain on hold, will help take some heat out of the NZD/USD. But there is much uncertainty how things will play out, given little clarity at this stage about President Elect Trump's spending plans. If these are as stimulatory as currently proposed, we may see a faster pace of Fed tightening through 2017 and 2018, inducing more downward pressure on the NZD/USD. Any policies that negatively impact global trade and prospects for Asian economies would also weigh on the NZ dollar.

Closer to home, the NZ dollar has held its ground against its Aussie counterpart, with the NZD/AUD around 94 cents. This has been despite relative commodity prices swinging sharply in Australia’s favour over the past three months, as the rise in dairy prices looks like small change compared to the 250% rise in coking coal prices. Iron ore prices have also risen strongly.

Exchange rates markets seem sceptical that the recent gains in hard commodity prices can be sustained. And rightly so in our view, with higher prices expected to choke off demand, and encourage a lift in supply. As such, we expect coal and iron ore prices to fall sharply in 2017, against a more stable outlook for New Zealand’s commodity prices.

Turning to relative growth and monetary policy, these don’t argue for a significant shift in the NZD/AUD over the next year. Policy rates are expected to be on hold in both countries for some time. But as growth in NZ begins to slow relative to Australia in 2018, we see the NZD/AUD edging lower.

Exchange rate forecasts (end of quarter)

This article was prepared by the full Westpac New Zealand economics team. Michael Gordon is the acting chief economist at Westpac New Zealand. This is the fifth and final chapter of their recent publication "November 2016 Economic Overview", and is here with permission. The first chapter is here, the second chapter here, the third chapter is here, and the fourth one here.