Roger J Kerr says the Reserve Bank has a great opportunity to catch the markets out with a surprise interest rate cut next month

By Roger J Kerr

Sentiment and forward market pricing of interest rate changes have been a case of shifting sand in both the US and NZ of late.

Two weeks ago the US short-term interest rate markets was pricing no Federal Reserve interest rate increases until early 2017.

However, improved US economic data through the second quarter after a traditionally weaker first quarter has changed that future expectation.

The US markets are now pricing a 50% probability of a Fed 0.25% hike in June or July and 100% chance by December.

Various Fed Governors are doing the softening up to make the markets aware that the mid-June meeting is very much “live” for a 0.25% increase.

Locally here in NZ, the moneymarkets have taken the US shift and extrapolated it to mean that there is now only a very small probability of a 0.25% cut at the Reserve Bank's Monetary Policy Statement on June 9.

The market’s rationale here is that the resultant stronger US dollar on global FX markets from US interest rate increases will drive the NZD/USD rate lower and the thus the Fed will do Governor Wheeler’s job for him.

I could agree with this view and market expectations if the NZD/USD rate was four cents lower at 0.6400 at this time. However, that is not the case and a Kiwi near to 0.6800 still makes the dairy sector very sick indeed for a third year in a row.

In my view, the RBNZ still have to make a choice as to what is more important for inflation and the economy at this time.

A 0.25% cut on June 9 would drive the NZD/USD lower as the majority do not expect a cut.

Such action would assist our largest industry to get back to break-even cash flows and have some glimmer of hope about the future.

It would also increase tradable inflation and that is what the RBNZ want.

Lower interest rates is not what the residential property market needs at this time. However, there are many other forces causing the supply/demand imbalance and continuous price increases.

If a failure to cut next month results in a Kiwi dollar back at 0.7000, the RBNZ would be heavily criticised for not following through with action behind their words of warning.

In the end a central bank loses its credibility if they always threaten, but fail to follow-through and deliver on the threats.

As I have stated in recent weeks, the RBNZ could learn a lot from the Reserve Bank of Australia in how to obtain maximum impact from interest rate decisions. If you desire the exchange rate lower, the best method is the surprise ambush when the markets do not expect an OCR cut. The RBA executed that strategy brilliantly well in March and a six cent AUD depreciation was the result.

The current market pricing for interest rates here means that the RBNZ have the opportunity to surprise the markets on June 9. But are they smart enough to take it?

provide the answers/guidance on how to unwind the QE stimulus. Ultimately the Federal Reserve need to sell all the Treasury Bonds they purchased. It may take 20 years to do so, however bond yields can only go up when they start.

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com