By Mike Jones and Kymberly Martin
The NZD was the strongest performing currency for nearly all of last week. After starting the week below 0.7800, the NZD/USD climbed to two month highs above 0.7950, driven by rising interest rate differentials and solid NZD/EUR and NZD/AUD buying.
Investors returned from the holiday period with all eyes on the Eurozone. Mounting European debt worries and a collapse in the EUR were the most eye-catching developments in markets last week. Given NZ’s superior economic and fiscal outlook, it’s hardly surprising the NZD was a beneficiary of the euro’s decline.
Indeed, solid demand from speculative and real money accounts propelled the NZD/EUR from 0.6150 to 0.6270 last week – the highest level since the euro was introduced. We think the NZD/EUR can go higher. As outlined in last week’s note (NZD/EUR: How High Can it Go?), PPP suggests the ‘peak’ in NZD/EUR could be as high as 0.6500-0.6600. However, technical factors and a heavily “long” speculative market raise the risk of a near-term pullback.
It’s worth noting, rising interest rate differentials also helped underpin the NZD last week. NZ-US 3-year swap differentials jumped from 215bps to around 240bps over the week, with similar movements seen relative to the other major markets (JP, UK, AU and EU).
Widening interest rate spreads has reduced the extent of “overvaluation” implied by our short-term NZD/USD valuation model. The model currently suggests a short-term “fair-value” range of 0.7350-0.7650.
‘Black’ Friday the 13th will no doubt be remembered in Europe for all the wrong reasons. The analysts at ratings agency S&P came back from holiday and promptly downgraded 9 of the euro area’s 17 member counties. The resulting market turmoil saw the EUR/USD collapse to 17-month lows below 1.2650. However, NZD/EUR buying again shielded the NZD from most of the the fallout. The NZD/USD tracked sideways in a wide 0.7860-0.7950 range, a strong performance under the circumstances.
For this week, the local data calendar begins to heat up. The Q4 QSBO, Q4 CPI, December electronic transactions data, Fonterra milk prices, and January consumer confidence figures are all due to be released.
However, we suspect most of the direction for the NZD will again come from offshore (read: Europe) this week (watch policy makers’ response and upcoming sovereign debt auctions). All up, we suspect the NZD/USD will struggle to sustain gains above 0.8000 in the absence of a material improvement in European market sentiment.
The USD strengthened against nearly all of the major currencies on Friday, thanks to a jump in investor risk aversion and a collapse in the EUR/USD.
A double dose of terrible European news sent markets into a tailspin on Friday. After months of rumours, ratings agency S&P finally took an axe to its European sovereign ratings. France and Austria were stripped of their AAA ratings, with a further 7 countries also suffering one or two notch downgrades. Germany escaped unscathed.
In addition, Greece’s creditor banks broke off talks with the government after failing to agree on the size of haircut they will take in a private debt swap. This increases the risk of a Greek sovereign default.
European and US equities recorded small losses (a weak JP Morgan earnings result weighed on US equities) and the VIX index (a proxy for risk aversion) rose from 20.50 to above 21.00. Credit spreads widened and renewed “safe-haven” demand saw US bond yields fall 1 to 6 bps.
In currency markets, EUR selling dominated proceedings. From above 1.2850 before the downgrades, the EUR/USD skidded back to 17-month lows around 1.2650 with all EUR crosses underperforming. EUR/JPY slipped from around 98.80 to 97.50 while EUR/GBP was knocked from 0.8360 to closer to 0.8280.
Along with the sliding EUR/USD, increasing “safe-haven” demand also underpinned the USD on Friday. As a result, most of the major currencies lost ground. Further bolstering USD sentiment, the Fed’s Lacker said the Fed should not be easing policy anytime soon.
Looking ahead, we suspect economic data will take a back-seat this week as sentiment in European debt markets remains in the driving seat for currencies. That said, there is plenty of (mainly US) data to keep an eye on. Note that, with US markets closed for Martin Luther King Day today, most of this data hits the markets later in the week.
All up, negative EUR momentum is firmly entrenched and we remain of the view investors will look to sell the single-currency on rallies this week. We maintain the same caution as last week though: heavily “short” EUR speculative positioning could spur the odd short squeeze higher. Near-term, EUR/USD resistance is eyed on bounces above 1.2850 with initial support at Friday’s 1.2625 low.
NZ swap yields rose by around 6bps across the curve on Friday, continuing the upward trend in place since the start of the year. 2-year swap yields broke above 2.89%, before closing at this level. This breaks the early December high. Technically, this leaves little resistance to yields rising back toward early November highs, close to 3.20%. Markets now price around 4bps of rate hikes from the RBNZ in the year ahead. These expectations have inched up from around -13bps at the start of the year. By contrast, we expect 75bps of rate hikes in the year ahead.
NZ bond yields also rose by around 5bps across the curve, on Friday. So far, this year however, rises in bond yields have been fairly contained. This has resulted in a notable widening in swap-bond spreads. For example, since the start of the year, 10-year EFP has widened from 21bps to 39bps, its widest level since August last year. This week’s DMO bond auction will be worth watching, after the rather tepid demand seen last week.
On Friday night, after much rumour, S&P finally downgraded nine European sovereign ratings (see above). The market reaction was relatively muted, though spreads to German bonds widened a little. For example Italian-German 10-year bond spreads widened from 479bps to 487bps. German and US “safe haven” 10-year yields closed lower at 1.76% and 1.86% respectively.
In the week ahead, we expect tomorrow’s NZIER business opinion survey to remain consistent with reasonable NZ economic growth. In addition, this week provides some insight into the global inflation picture, with NZ and US CPI releases on Thursday, and Eurozone and UK’s on Tuesday.