Roger J Kerr says the foreign exchange markets are looking further ahead than the Reserve Bank's interest rate cut

By Roger J Kerr

The RBNZ did not make the decision I expected last week and the financial markets reaction was not what I would have expected either. So, surprises all round on that front.

However, we are back to where we started with both interest rate and exchange rate levels.

A week ago I opined - “The FX markets do not see the RBNZ cutting the OCR this week and even if they did the RBNZ might then signal they are in “neutral” mode as the RBA have recently done”.

The forward guidance from the RBNZ on their assumed 90-day interest rate track over the next three years was for the interest rate to stay above 2.60%.

The forex markets interpreted that as a subtle shift in signal from an “easing” bias for future monetary conditions to a “neutral” stance. Therefore, the NZD/USD exchange rate instead of depreciating as most were expecting on a cut, in fact appreciated up to a high of 0.6775 from 0.6640.

That slightly altered message from the RBNZ was seen as positive for the Kiwi dollar as FX markets are always looking to future economic/monetary conditions and pricing those into today’s exchange rate.

The prime objective of the RBNZ’s decision to cut the OCR to 2.50% seemed to be to get the NZ dollar exchange rate down and that in turn would drive the annual inflation rate back into the middle of the 1% to 3% target band (imported consumer goods going up in price). That strategy has so far back-fired on the RBNZ as the FX market’s reaction was most likely the opposite of what they would have been expecting.

The RBNZ should have a pretty good idea in advance of how their statements will impact FX market direction. They will also be surprised at the higher Kiwi and thus may be thinking (in hindsight) that the alternative strategy of not cutting the OCR, but maintaining the easing bias message would have been more effective in the driving the Kiwi dollar lower.

The only impact on the economy and financial markets from the decision to cut the OCR to 2.50% appears to be the banks immediately dropping their variable mortgage interest rates to 5.75%. Such a change will have little impact on the housing market as a growing percentage of home mortgage borrowers target the lower one to three year fixed rate deals. One to three year wholesale swap rates were largely unchanged after last Thursday’s statement in the 2.75% to 2.90% region.

One major change in the RBNZ’s outlook for the NZ economy since their September statement is that they now expect the annual inflation rate to take a much longer time to increases from the current +0.40% to the 2.00% target. They correctly see the economy stronger than they did in September and the global risks have reduced.

The RBNZ forecast of the economy expanding by 1.20% over the second half of 2015 appears to be on the light side. The September quarter’s GDP growth figures are due to be released on Thursday 17^th December could well be above RBNZ forecasts of +0.60%, expansion in the +0.80%/+0.90% for the quarter area would not surprise me.

The short-term direction of the NZD/USD exchange rate from the current spot rate of 0.6725, in my view, will be back to the previous 0.6400/0.6600 range, for three principal reasons:-

• The US Federal Reserve’s interest rate hike should send the EUR/USD exchange rate back to $1.0600 from the current $1.1000 level i.e. a stronger USD against all currencies in the lead up to Xmas.
• There was no “follow-through” buying of the Kiwi dollar after the spike up to 0.6775. Over coming days there should be further unwinding of long NZD dollar positions put on last week.
• The Australian dollar has so far been very resistant to the plunge in metal and mining commodity prices over this last week. The CRB Commodities Index is down 10% to 175, so expect the Kiwi to follow a weaker AUD over the next few weeks.

Exporters however need to have orders placed to pick up further hedging in the 0.6400/0.6600 range as the medium to longer term outlook for the Kiwi dollar remains positive with relatively higher interest rates, relatively higher economic growth and further recovery upwards to come in dairy prices. A bad summer drought hitting agriculture remains as the major risk to that positive Kiwi dollar view.

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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