Attractive interest rate yield differential between NZ & US should see NZ$ at around 82 cents

By Mike Jones

NZD

The NZD/USD drifted back below 0.8100 last week, as the USD finally found some friends.

Overall, it was another week in which positive rhetoric and hopes for central bank stimulus managed to overcome worries about the deterioration in global economic data.

Investors’ glass is definitely half full. Indicative of such, our risk appetite index (scale 0-100%) climbed to 16-month highs – a big positive for the ‘risk-sensitive’ NZD.

But it was last week’s lurch higher in US bond yields that had everyone talking. The near 20bps increase in 10-year Treasury yields underpinned a mild strengthening in the USD, as expectations of additional Fed easing were wound back a notch.

While the firmer USD provided headwinds for the NZD/USD at times, it’s worth noting that NZ-US interest rate differentials actually finished the week broadly unchanged.

NZ-US 3-year swap differentials currently sit at 233bps, from 227bps last week. A key tenet of our constructive NZD/USD view is that the currency’s attractive yield differential will remain in place over the coming 6-9 months. We continue to target 0.8200 by year end.

For this week, there‘s a steady trickle of NZ data to keep an eye on, although it’s pretty much all second tier stuff.

Tomorrow’s quarterly RBNZ survey of expectations will probably be the highlight. The RBNZ will be hoping the 2-year inflation expectations measure drifts down further from Q2’s 2.4%y/y. An increase would be the biggest surprise for a market still toying with RBNZ rate cuts.

Across the Tasman, it’s similarly quiet, with just Tuesday’s RBA Board minutes and Friday’s Stevens speech worthy of a mention.

It was a strong week for the NZD/AUD last week, with the cross pushing up to 0.7750 by Friday. We think further NZD/AUD gains are likely.

However, we have trimmed our year-end forecast slightly. The RBNZ now set to keep its OCR on hold for longer, while the RBA seems inclined unlikely to cut again.

As a result, we’ve scaled back our Q4 forecast to 0.8200, from 0.8400. All up, we suspect the NZD/USD is in for a bit more sideways consolidation this week. A convincing break through key support at 0.8020 would likely pave the way for a deeper correction back towards 0.7850.

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Majors

The USD finished last week on a firmer note. The narrow DXY index spent Friday night edging up towards the recent 82.80 high.

Currency markets remain largely directionless. A lack of notable data and events, and thinning volumes thanks to the European summer, has seen volatility drop to multi-month lows.

Indeed, the VIX index (a proxy for risk aversion based on the implied volatility of the S&P500) fell to a fresh 5-year low on Friday.

Probably the most noteworthy development of last week was the surge in US bond yields. 10-year Treasury yields climbed from 1.65% to almost 1.85%.

The US economic news certainly wasn’t a picture of health, but positive surprises now appear to be outnumbering negative for the first time in several months.

As a result, investors tempered their expectations for Fed easing somewhat. The gains in US yields saw the USD hold its ground last week (and strengthen relative to the AUD and NZD), despite increasing investor demand for ‘pro-risk’ assets.

Looking ahead, we doubt the trend for higher US yields will be able to extend much further, ahead of Fed chairman Bernanke’s seminal address to the Jackson Hole Summit at the end of August.

This should limit the topside for the USD in the near-term. We’ll get an update on the Fed’s thinking from this week’s FOMC minutes. However, these predate the recent improvement in US data and are unlikely to be market moving.

Elsewhere, Thursday’s Chinese and European PMIs are likely to be the highlight of an otherwise quiet week. Analysts are hoping for a small improvement in the European readings.

In the UK, all eyes will be on the second estimate of Q2 GDP (-0.5% expected). Lastly, keep an eye on the newswires with a few key European policy meetings due to take place this week (Samaras/Merkel, Samaras/Hollande, Hollande/Merkel).

All up, it’s shaping up as another range-bound week as investors await the important events of late August/early September.

However, we could see EUR/USD test the 1.2445 top end of its range if European PMIs improve as expected and policy makers again attempt to bolster confidence in Eurozone debt markets.

Other News: German finance minister rules out a third bailout for Greece – “It can’t be helped - we can’t make yet another new program. There are limits". Chinese house prices rise 0.15%m/m in July (-1.8% y/y), marginally better than analyst expectations. US Michigan consumer confidence beats expectations at 73.6 in August.

Event Calendar: 20 August: NZ PSI; UK house prices; US Chicago Fed index; 21 August: NZ net migration; NZ credit card spending; NZ inflation expectations; AU RBA minutes; UK public sector borrowing; US Fed’s Lockhart speaks; 22 August: US existing home sales; US FOMC minutes; 23 August: CH HSBC Flash PMI; EU PMIs; US jobless claims; US new home sales; 24 August: NZ trade balance; AU RBA’s Stevens testifies; JN BOJ’s Shirakawa speaks; UK GDP; US durable goods orders.

All its research is available here.