Opinion: NZ$ below USc 50 in early 2009?

By BNZ Currency Strategist Danica Hampton The NZD/USD has fallen nearly 10% over the past month, from above 0.5800 to below 0.5200, pressured by deepening gloom about the global outlook. The global outlook is the key driver of the currency at the moment. What started out as problems in the US sub-prime mortgage market over a year ago quickly spilled across into a generalised financial crisis. Global equity markets have fallen more than 50% over the past year, credit and cash markets have broken down and borrowing funds has become more difficult and more costly. Despite radical measures taken by governments and central banks around the world, the financial crisis has taken a toll on global growth. Most industrialised economies are in recession or on the brink of recession and both the IMF and the OECD have slashed their forecasts for global growth in 2009 and 2010.

The rapidly deteriorating in the global outlook affects the NZD/USD through two key channels: * Risk aversion and global deleveraging; * Falling commodity prices * Risk aversion and global deleveraging As the global economy becomes more challenging, investors typically switch to more traditional asset classes and more traditional markets. Over the past few months, generalised uncertainty and extreme risk aversion has seen investors ditch risky assets, like equities and emerging market debt, in favour of the relative safety of government bonds and money market instruments. Given the substantial funds under management held by US and Japanese investors these global deleveraging flows tend to underpin both USD and JPY. Heavy losses across global equity markets and escalating risk aversion simply intensify these global deleveraging flows. While we're talking about the outlook for the USD, let's have a word on quantitative easing. In addition to slashing interest rates, the Fed has started purchasing securities (in effort to help free-up banks balance sheets and encourage more new lending). The US monetary base has grown by more than 30% since August, which effectively means the Fed has started quantitative easing (i.e. increasing the money supply). At first blush, you'd might think increasing the US money supply would decrease its value and undermine the USD. However, the key to whether or not quantitative easing erodes the value of the USD is inflation. Certainly, if increasing the money supply stokes inflation or inflation expectations you would expect it to undermine the value of the USD. However, the current global backdrop is disinflationary thanks to falling global demand and heavy declines in commodity prices. In fact, investors are actually quite worried about deflation, hence why global yield curves have flattened so much and probably why the Fed has started quantitative easing in the first place. Against this backdrop, quantitative easing is unlikely to stoke inflation expectations and so it is unlikely to result in significant USD weakness. Certainly, the Fed will need to be wary of running quantitative easing for too long as it will eventually spark inflation once the US economy starts to recover. But for at least the next 3-6 months, we think inflation expectations will be a non-issue. We've already seen a lot of "global deleveraging" and as a result USD and JPY have been the strongest performing currencies over the 2008. Nonetheless, our risk appetite index is currently sitting around 20%, well below the 50% threshold that signals risk aversion. While the global backdrop continues to deteriorate, risk aversion remains rife and investors keep channelling funds into "˜safe-haven' investments, global deleveraging flows will continue to underpin the USD and JPY. As a commodity exporting nation New Zealand's economic well-being is inherently linked to global demand. The global price of NZ's export bundle, as measured by the CBA commodity price index in SDR terms, has fallen nearly 30% from the highs seen in November 2007. The deterioration has been led by a correction in dairy prices, which have fallen about 50% from the highs seen last November and are expected to fall a further 15-20% over the coming six months. Any further fall in the price of NZ commodities and/or scaling back of global growth expectations simply adds to the risks facing the NZ economy and the NZD. The world won't continue to worsen indefinitely. Eventually, the bevy of aggressive interest rate cuts and all the measures taken by governments around the world will help shore up the global economy. However, the recovery will take many months. Meantime, fears about the health of the global economy will likely remain the order of the day, and bad news for NZD/USD. Local news adds to risks While global developments have taken centre stage over recent weeks, the local backdrop adds to the downside risks facing the NZD. NZ is now in its fourth quarter of recession. We're starting to get through the first phase of the slow-down, which was characterised by falling house prices and sluggish retail spending. In the second phase, expect to see further job losses and rising unemployment. We've recently revised down our growth forecasts for 2009, from an annual average rate of 1.3% to a paltry 0.4%. Whichever way you look at it, the near-term outlook for NZ is undeniably ugly. In response to the NZ recession, and the deteriorating global backdrop, the RBNZ has cut interest rates by 325bps to 5.00%. While the central bank acknowledges monetary policy is now in an expansionary" position, with the global backdrop showing few signs of stabilising and local inflation pressures continuing to dissipate further rate cuts are likely. We look for the RBNZ to cut a further 50bps in January and continue cutting until the OCR troughs somewhere between 3.50% and 4.00% next year. With US interest rates already at the relatively low level of 1.00%, there is limited scope for further US rate cuts. Consequently, further RBNZ easing will likely see NZ-US interest rate spreads narrow, thereby reducing the yield support for NZD/USD. Over the next few months, the downside will remain the greater risk for the NZD/USD. While the global backdrop continues to deteriorate expect the NZD to keep falling against the USD and the JPY. Our forecasts have the trough pencilled in at 0.5000 and 45.00 respectively, but this could well be too optimistic if the global recession ends up being deeper and more prolonged than currently anticipated. However, given the immense uncertainty about the global outlook and the extreme volatility we've seen in NZD/USD, expect the path lower in the currency to be very bumpy. In the near-term, continue to keep an eye on global equities for clues on NZD/USD sentiment. We suspect NZD/USD will face headwinds on bounces towards 0.5550 and in the absence of a significant improvement in risk appetite and global equities 0.5600 will prove too great a hurdle. Some support is seen ahead of 0.5250, but a retest of November's sub-0.5200 lows could be seen in coming sessions. * Danica Hampton is BNZ's Currency Strategist. All of the research produced by the BNZ Markets team of economists is available here.