Roger J Kerr says the US Federal Reserve has adopted a measured middle path – and the net/net result is that it remains US dollar negative

Summary of key points: -

- Fed nearing the end of its monetary tightening cycle
- Kiwi dollar underperforms the Euro in the weaker USD environment
- Investment banks “talking their own book” with negative NZ dollar forecasts

Fed nearing the end of its monetary tightening cycle

Last week’s decision and messaging by the US Federal Reserve was always going to be a tricky balancing act of not scaring the horses in the financial/investment markets, however retaining confidence that they remain serious about reducing inflation without damaging the economy. Chair Jerome Powell appears to have adopted the appropriate middle path with a 0.25% interest rate increase, whilst commenting it would have been 0.50% had not bank credit conditions tightened in response to the banking collapses. It is too early to gauge how the tightening up of credit will slow economic activity and take the pressure off inflation. The US dollar weakened following the Fed statement as the wording was changed from “ongoing interest rate increases” to “some additional increases may be appropriate”. It all adds up to further signs that they Fed are estimating they have nearly done enough with interest rate hikes. Whether the tougher credit and monetary conditions lead to a bad recessions remains to be seen. Our views is that the banking problems are contained and as time goes on the risk, of the banking crisis causing a sharp slide into recession, reduces.

The implications of these recent banking problems and the US Fed’s and US Government’s responses with liquidity and depositor protection support on currency movements is that US will be ending their monetary tightening cycle earlier than both Europe and New Zealand. Further US dollar weakness has to be expected as their two-year Treasury Bond interest rate plummets again from 4.20% a week ago to 3.58% currently. The market is pricing-in US interest rate cuts later this year. The Fed does not agree with that pricing, however as the future economic data comes out weaker and the annual US inflation rate continues to reduce, the markets may well prove to be more accurate on what eventuates. New Zealand’s two-year Government Bond interest rate is 4.66%. therefore currency investors and speculators will continue to shift away from holding US dollars to higher yielding currencies.

Important US economic data being released this week includes house prices and the PCE inflation measure for February. Again, there is a good chance the February core PCE inflation rate will come in lower than the +0.60% prior forecasts.

The USD Dixy Index has decreased 3% from 106 to below 103 over the month of March, further reductions to below 100 have to be expected given the growing US interest rate gap to other currencies.

Kiwi dollar underperforms the Euro in the weaker USD environment

It could be argued that the RBNZ and the ECB in Europe are at similar stages in tightening monetary policy. Both central banks becoming closer to the end of the tightening cycle, however some interest rate increases still to come to pull down the stubbornly high inflation rates. Therefore it should be reasonably expected that the historically high correlation between the NZD/USD rate and the EUR/USD rate would hold through the early part of 2023. However, that has not been the case with the Kiwi dollar, as a “risk proxy” currency, underperforming the Euro against the USD since December 2022.

The first chart below, the NZD/EUR cross-rate (which is a straight mathematical calculation of the two independent exchange rates against the USD) has consistently declined from 0.6100 in December 2022 to 0.5770 today, confirming how much the Kiwi has underperformed the Euro over this period.

Explanations as to why the Euro has strengthened further against the USD than the NZD may be summarised as follows: -

• The initial fallout from the banking troubles in the US have generally been negative for equity markets and therefore risk currencies like the NZD and AUD. Less so for the Euro.

• The ECB continued with its 0.50% increase in interest rates last week, despite the credit shock in the US markets, was also a Euro positive factor.

• The Swiss state sponsored buying of Credit Suisse by UBS was viewed by the forex markets as a positive for the Euro in its own right, appreciating up to $1.0900 against the USD. However, it is not a good look for the renowned Swiss banking standards and reputation when one of the two largest banks has to bail the other one out due to some basic and inexplicable mismanagement.

• New Zealand’s economic news has not been too flash lately which does not help the sentiment towards the NZD. An increased external Current Account deficit (due to tourism being decimated in 2020 and 2021) and a larger than forecast GDP contraction in the December 2022 quarter, together painting a picture of an economy that is struggling in the post-Covid/tight monetary policy era.

• A number of FX market reports stating that if the banking crisis and tightening of bank credit conditions in the US does force a hard landing of the US economy into recession, the NZD has historically under-performed other currencies against the USD in these conditions because a global recession always causes lower commodity prices (therefore NZD negative).

At 0.5770, the NZD/EUR cross-rate is back to the lows it traded to in October 2022 when the Kiwi was briefly slammed down to 0.5500 against the USD. The economic and monetary conditions today are not as positive for the USD as they were in October. It does appear that the NZD/USD rate has some catching-up to do vis-à-vis the recent Euro gains against the USD.

The second chart below confirms that the two exchange rates do not vary away from each for too long. The Kiwi certainly outperformed the Euro in mid-2022 when the war prevented the ECB from increasing interest rates at the time. The EUR/USD rate now up to $1.0900 suggests that NZD/USD should be trading higher to around 0.6500. It is only a matter of time before some speculative hedge funds see this divergence and buy the Kiwi against the Euro. Why would they not entertain that trade, as the interest rate differential between the two currencies provides a nice forward point advantage starting point.

Investment banks “talking their own book” with negative NZ dollar forecasts

If you firmly believe that the US and global economy is headed to a definite and deep recession due to the US banking problems, you may find some agreement with the recent view of US investment banks JP Morgan and Morgan Stanley that the NZ dollar is a prime candidate to sell as a hedge against other currencies.

Firstly, we do not see the current US banking pressures as serious enough to cause a dive into recession. Liquidity and support is massive to ensure that does not happen.

Secondly, one should be very cynical and suspicious about these investment banks recommending such currency trades. Typically. they are already holding short-sold NZD positions themselves in their own proprietary trading desks and therefore are “talking their own book” with “research” pieces to their clients to sell the Kiwi dollar.

Our counter argument to these views is that a slowdown in the US economy does not automatically mean a global recession, lower commodity prices and therefore a lower Kiwi dollar. The currency strategy recommended also ignores the strong NZD dollar link to a rapidly recovering Chinese economy and the fact (as stated earlier) that the RBNZ tight monetary policy is going to last a lot longer in 2023 than the Fed’s tight policy. Therefore, the pre-conditions for the Kiwi dollar to depreciate are not present in a continuing weaker USD environment. The dominant influence over the NZD/USD exchange rate over the last two years, the direction of the US dollar itself, will continue to be the driving force over coming months.

The current 0.6150 to 0.6300 trading range will not continue indefinitely. Stronger Chinese economic data, weaker US data and a return of confidence into the AUD all suggest a break out of the top-side to 0.6300 and higher over coming weeks.

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