Roger J Kerr says the RBNZ may consider cancelling OCR increases in June/July if the exchange rate stays high

 By Roger J Kerr

The New Zealand dollar has returned to near its highs of 0.8670 against the USD, boosted by continuing strong local economic data, rising NZ interest rates that are attracting “carry-trade” buying of the NZD and a failure of the US dollar itself to make gains despite stronger US employment growth in April.

The overall value of the NZ dollar measured by the TWI Index has returned to be near its highs at 80.5, considerably above the assumed/forecast exchange rate level the RBNZ are applying to their 2014/2015 inflation forecast and thus the upward track in the OCR interest rate.

A continuation of the TWI above 80 over coming weeks must force a reasonably large adjustment downward in the RBNZ’s updated inflation forecast which they will be producing with the Monetary Policy Statement on 12 June.

In turn, this change to the expected inflation track may prompt the RBNZ to postpone or even cancel the next 0.25% OCR increase scheduled and market priced for June/July.

Such a decision would be negative for the NZ dollar at the time if it does not depreciate on its own accord over the next month.

Variable in play in the NZ dollar forex marketplace over coming weeks, outside RBNZ OCR decisions, include:

• Whether the FX markets will eventually react to falling Wholemilk Powder (WMP) dairy prices? WMP prices have plummeted 22% since February in the GDT online auctions to below USD4,000/MT, however so far the Kiwi dollar has not followed and has moved in the opposite direction. Further price reductions seem likely at upcoming auction dates on 6 and 20 May as the globally traded WMP market adjusts to additional supply coming from Europe. The price divergence between New Zealand’s key commodity export (lower) and the NZD (higher) is now very pronounced and it is inevitable that GDP growth forecasts will be revised downwards if the divergence continues for much longer. It has been surprising that the currency markets have not marked the NZD down already on the falling WMP prices. However, for the short-term rising interest rates and other positive domestic economic data have outweighed the WMP and NZD divergence. In the medium term the sharply lower milksolids payout and income to the dairy sector that will result is decidedly negative for the NZ economy.
• The Australian dollar appears poised for further depreciation against the USD; potentially returning to below 0.9000 over coming weeks (currently 0.9360) as weaker economic data (e.g. manufacturing) and Government budget erode investor and currency trader confidence. The 13 May budget will be very much in the “austere and tough” category and thus more negative than positive for the Australian economy and thus currency value. It is becoming increasingly apparent that there is insufficient economic growth in the non-resources sectors to replace the lower activity levels from the large resources capital projects coming to an end. The Australian economy desperately needs a lower exchange rate and like 12 months ago, the budget and Government finances could well prove to be the catalyst to trigger another AUD sell-off. The NZD would follow the AUD lower in this situation.
• To date the US dollar has failed to make gains from the continuously improving US economic numbers. Last week’s 288,000 jobs increase for the month of April was well above prior forecasts; however the USD remains at the $1.3850 level against the Euro. It appears that the FX markets have reduced their bets (i.e. bought Euro/sold USD) that the ECB will embark on a QE type monetary stimulus package. However, there is a high probability that the ECB will announce such a policy change and the balance of risk has to be that the Euro will weaken significantly to $1.3000 when they do.
• The opposition Labour Party’s economic policy announcement last week failed to move the markets, Whilst designed to lower the NZ dollar value and maintain lower interest rates by reducing the Current Account deficit and thus reliance on foreign investment inflows that bid up the currency value, the consensus reaction was that small adjustments to the Kiwi Savings ratio would not be a game changer for the now permanent Current Account deficit around the 4% of GDP level. The external deficit is largely the result of the high level of foreign ownership of NZ businesses and thus structural in nature, not cyclical due to us failing to pay our way in the world due to exports not covering our import demand. The expansion of the RBNZ’s remit to the Current Account deficit, employment and growth is really impossible to achieve with so many other investment/business factors at work in the economy outside the RBNZ’s control and influence. Additionally, there is some unease about tampering with an individual’s retirement savings plan for unrelated macro-economic policy objectives. Overall, the political risk factor for the NZ dollar surrounding the September general election appears to have reduced with Labour failing to get traction in the political opinion polls. However, a lot can change in four months and the current high optimism levels on the economy is likely to reduce over coming months with rising mortgage interest rates and lower dairy farmer incomes.

The NZD/USD exchange rate has held up at the higher levels above 0.8500 for longer than anticipated given the sharp drop in WMP prices.

It seems it will require a change in sentiment towards the USD globally to create the FX market environment for a lower Kiwi dollar.

Such a change in direction of the USD itself cannot be too far away. 

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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