Opinion: Credit Crunch makes 50bps OCR cut more likely

By BNZ Currency Strategist Danica Hampton Reading the headlines in the financial section over the past few days, you'd be forgiven for thinking the world is coming to an end. Lehman Brothers, a corner stone of the US banking industry, has filed for bankruptcy. Merrill Lynch has been purchased by Bank of America and AIG, the United States' biggest insurance company, is struggling for survival. Financial institutions have become very reluctant to lend anything to anyone, in case they have large exposures to Lehmans, AIG, or the next financial disaster that may be lurking around the corner. These counterparty concerns have seen tensions across global money markets escalate and short-term money market rates skyrocket. Market participants around the world are left struggling to digest what it all means for equities, interest rates and currencies. Fraught with uncertainty, most investors are reacting to every headline and financial markets have become extremely volatile. Expect this volatility to remain, while uncertainty persists. The credit crisis is not new news. We've been talking about the slump in credit markets and the struggles plaguing the banking sector for over a year now. While there is a lot of uncertainty as to how long it will last and how bad it will be, there are four things we know with certainty.

• There is no quick fix to the credit crisis.
• Central banks around the world will continue to inject liquidity into cash markets in order to keep the financial system functioning. But don't expect central banks to bail investors out of poor credit decisions.
• There will be less credit available and it will cost more.
• Higher lending rates across the globe will act as a handbrake on the global economy.

What does it all mean for NZ? When considering the implications of the credit crisis, the biggest mistake to make would be think it will not impact NZ. As a commodity exporting nation, New Zealand's economic well-being is highly leveraged to global growth and, because of its large current account deficit; NZ is also dependent on offshore funding. If everything else was held constant, the credit crisis and melt-down in financial markets would result in higher lending rates for New Zealand consumers and businesses. Luckily, we are not operating in a vacuum and the RBNZ has shown a proactive willingness to ease financial conditions (evidenced by last week's 50bps rate cut in the OCR). The latest bout of financial market turmoil simply raises the risk that the RBNZ will have to be more aggressive about cutting interest rates over coming months. As the financial backdrop deteriorates, the odds off the RBNZ cutting another 50bps in October rise and so too do the chances of the OCR falling further below the projections published in the September Monetary Policy Statement. Overall, the financial crisis increases the scope for further downside in NZ interest rates, particularly in the front-end of the swap curve. Our central forecasts have the 3-year swap rate troughing around 6.20-6.40%, but a worsening of the global financial crisis increases the chances of the swap rate falling even further. Despite the recent turmoil, we'd caution against getting overly pessimistic on swap rates further out the curve. The NZ yield curve typically steepens during an RBNZ easing cycle, as longer-term rates tend to be anchored by international rates and dramatic cuts in the OCR tends to inflate longer term inflation expectations. The backdrop of a global slow-down is, of course, bad news for a commodity exporting nation like NZ, where economic growth is highly leveraged to both the global economy and the price of NZ's export bundle. Overlay the deteriorating global picture with a domestic economy on the brink of recession, and falling NZ interest rates, and the medium-term risks to the NZD/USD are undeniably to the downside. Our central track is for NZD/USD to fall to 0.6200 by year-end and to trough around 0.6000 in early 2009. However, should the credit crisis escalate (prompting more aggressive RBNZ action) or become more prolonged (raising the risk of a global recession) this simply means the NZD/USD is likely to fall faster and further than our current forecasts. While the outlook for the financial sector remains fairly bleak, to date, the corporate sector has been relatively untouched by the recent deterioration in capital markets. But this is unlikely to continue. As bank funding margins continue to widen this will likely affect the borrowing cost of corporates. To date, corporates offshore have been able to borrow in the offshore capital markets at levels not too much higher than a year ago and below those of banks. Whether this is a case of investors paying up for diversity or a case of investors yet to adjust their pricing expectations for the corporate sector is unknown. The reality is that as the banking sector faces the challenge of meeting its capital funding requirements, we are more likely to see banks ration their lending lines. This will force some bank borrowers into capital markets, and as this momentum grows investors will demand wider margins to differentiate between issuers. The key message for the corporate sector is if you see a good deal now don't hold off in the hope that a better one may be down the road. It's likely conditions will worsen before they improve.