By Roger J Kerr
Last week, not just because it was the Melbourne Cup horse-racing week, the Reserve Bank of New Zealand (RBNZ) seemed to be taking a “bob-each-way” on the outlook for the economy, thus future inflation and interest rate moves.
The RBNZ, quite rightly, are recognising the strength of the economy right now and stuck with their GDP growth forecast above 3.00%.
Coupled with renewed inflationary pressures from higher oil prices, lower currency and the prospect of higher wage settlements from policy changes of the new Government, the RBNZ were forced to drastically adjust their 2018 inflation forecast upwards.
The more positive or bullish outlook is justified and a step up from the more sanguine forward view just a few months ago in August. The optimistic scenario brings into play earlier increases in the OCR in 2018 and thus positive for the Kiwi dollar against all the other currencies who will not be increasing interest rates (e.g. Australia and Europe).
However, on the other hand, the RBNZ kept their options open to the more pessimistic scenario going forward for the economy as they say it is too early to see what all the policy changes from the new Government will mean for the economy. Call this the “Winston slowdown” put option on the economy where business and consumer confidence takes a dive, economic growth falters and therefore inflation stays low.
In this scenario, business firms may have to pay higher wages to retain and attract workers, however slowing sales means they will have no power to recoup the increase costs through increasing the prices of their products and services. If the pessimistic scenario transpires into reality, the RBNZ will delay OCR increases until well into 2019 and the NZD/USD exchange rate may struggle to get back above 0.7000.
Early indicators as to which way the NZ economy will travel in 2018 will be business and consumer confidence survey results over coming months. Further significant decreases in both indices will be negative for the Kiwi dollar. A major influence on consumer sentiment will be changes to house prices through the “wealth effect” on household spending habits.
Auckland house prices have levelled off over recent months, the most significant reduction on the demand side actually occurred 12 months ago as tighter LVR rules kicked in for investment properties and tighter exchange controls in China abruptly slowed buying demand from that source. The residential property market in the provinces remains pretty robust on the back of strong employment levels from record high export commodity prices.
Over coming months, my expectation is that business and consumer confidence will not fall away and the more positive scenario for the economy will come through. Therefore, the forces determining the value of the Kiwi dollar from New Zealand-centric factors will be mildly positive. A return to the 0.7000 to 0.7200 trading range is the more likely outcome. Gains above 0.7200 should be tempered by a modest strengthening of the USD on global FX markets.
In addition to the overall performance of the NZ economy and RBNZ responses to that, the other major driving force on the Kiwi dollar is dairy prices.
Whole milk powder (WMP) prices have declined at the last three GDT dairy auctions to below US$3,000/MT. However, Fonterra has maintained their $6.75/kg milksolids payout forecast to dairy farmers, indicating that they may have sold more end-product forward at fixed prices than what the market has factored in.
The next GDT auction results on Wednesday 22 November will be an important milestone for WMP price direction. In particular, as to whether the increased European WMP production and supply has been absorbed by the demand side from buyers. The demand side should be receiving a new boost from oil-producing nations as the higher oil prices provide the extra cash to import more food protein such as WMP.
Oil and WMP prices have historically maintained a close correlation for this reason. However, of late oil has increased and WMP has decreased, resulting in a significant divergence in the two prices.
The NZ dollar is forecast to continue to make further gains above 0.9000 against the Australian dollar following the drop to 0.8850 on the political risk sell-off the Kiwi a few weeks back.
Looking ahead, the NZD/AUD cross-rate could well climb back to 0.9200 on the basis of both interest rate differentials and commodity price differentials being more favourable for the Kiwi.
Our political risk event is well and truly over, whereas the Turnbull Government in Australia faces fresh uncertainties with the “dual nationality” saga causing a loss of their majority in the house.
Over the last five years the NZD/AUD cross-rate has traded between 0.8800 and 0.9700, reversing direction abruptly when reaching these outer limits. Speculative and investment related FX market positioning has caused this pattern in this relative exchange rate and there is no reason to believe that the past behaviour will change.
Roger J Kerr contracts to PwC in the treasury advisory area. 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