By Danica Hampton NZD/USD climbed above 0.6200 on Friday night to a 7-month high. Once again, the key theme was USD weakness. Increasing concern about the US fiscal deficit, worries the US may lose its triple-A credit rating and talk that Asian central banks are diversifying foreign reserves saw the USD weaken against a broad range of currencies. In fact, the USD Index fell 3.6% last week to a 5-month low. Against the backdrop of a generally weaker USD, solid demand from real-money investors and Asian retail accounts saw NZD/USD climb from around 0.6120 to nearly 0.6240 on Friday night. However, NZD/USD has opened the week under 0.6150, on a softer footing, thanks to the announcement of US dairy subsidies over the weekend. US Agriculture Secretary Tom Vilsack announced subsidies for 92,000 tonnes of dairy exports, saying it was in response to the European Union's export subsidies earlier in the year. Both Fonterra and the NZ Trade Minister have strongly criticised the announcement, which has come in spite of the recent pledge by G20 nations, including the US, to refrain from protectionism.
For the coming week, the focus in currency markets will remain on the USD. Investors will be closely watching this week's US Treasury bond auctions (there's US$101b worth of two, three and seven year bonds being offered). Should investors remain concerned about how the US government will fund its budget deficit, and longer dated US bond yields continue to rise, we'd expect USD weakness to keep NZD/USD underpinned on dips towards 0.6000. However, we expect the NZD to under perform against the crosses. Locally, Thursday's 2009 Budget will be the main event. Despite increasing rhetoric around the need for fiscal restraint (something entirely appropriate, given the circumstances), Treasury's updated outlook for the Crown accounts will likely make for very sorry reading. Last December's DEFU (which contained spectacularly over-optimistic forecasts) expected bond issuance to reach 10% of GDP by 2012. The economic deterioration since the DEFU will surely be reflected in wider core deficits and an even greater need for debt funding. We believe Standard & Poor's will refrain from downgrading New Zealand's sovereign rating over the near term (having placed us on negative outlook back in January). However, it's worth noting, that Moody's and Fitch have NZ effectively a notch above S&P and on a stable outlook. So, while we (and most others) expect S&P to hold its NZ rating in the wake of this week's Budget - it's not inconceivable that either Moody's or even Fitch takes the opportunity to put their NZ ratings on negative outlook, if not formally downgrade. The USD weakened sharply against most major currencies on Friday night, amid deepening concern over the burgeoning US fiscal deficit and growing questions about its "safe-haven" status. The deteriorating USD sentiment is linked to concern that the US may lose its AAA credit rating (heightened after Standard and Poor's cut the outlook for the UK's sovereign rating). China's questioning of the USD's role as the world's reserve currency and persistent rumours about Asian central banks diversifying foreign reserves simply added to the heavy USD tone. US bond yields climbed on worries over the funding of the huge budget deficit, with some traders also disappointed over the size of the Fed's purchases, especially with US$101b in two, three and seven-year notes to be issued this week. Tensions across the financial system also eased last week, which helped benefit risk appetite and reduced "˜safe-haven' demand for the USD. Interbank funding costs measured by the 3-month US libor to OIS spread have more than halved since mid-March to 45bps, their lowest since February 2007. The VIX Index (the implied volatility of the S&P500) has fallen to pre-Lehman Brothers collapse levels of around 30% and our risk appetite index (which has a 0%-100% scale) has risen to 30%, well off the 15% low seen in early March (although still below its long-term average of 50%). Over the course of last week, the US 10-year government bond yields climbed more than 30bps to a 6-month high of 3.45% and the USD Index fell 3.6% to a 5-month low of 79.80. Against a generally weaker USD, EUR/USD climbed from below 1.3500 to above 1.4050 last week. However, European officials are clearly uncomfortable with the recent rise in the EUR. On Friday night, Eurogroup Chairman Juncker warned that further EUR strength could hamper a Eurozone recovery. For the coming week, we expect the focus to remain on USD sentiment. Specifically, investors will be closely watching how the market absorbs this week's US Treasury bond auctions and whether or not the Fed steps up its purchases of government debt. Should investors remain concerned about how the US government will fund its budget deficit, and longer dated US bond yields continue to rise, we'd expect the USD to remain under selling pressure. ____________ * Danica Hampton is BNZ's Currency Strategist. All of the research produced by the BNZ Markets team of economists is available here.