Outlook for the New Zealand Dollar Improves as the Bar for Raising Rates Just Got Higher

The prospect of another New Zealand interest rate cut in coming months has just decreased further.

The progression of interest rates is fundamentally important for the outlook of the NZD.

Currencies continue to be driven by interest rate differentials - the higher yield offered in New Zealand over recent years (2.5-3%) has benefited the NZD, particularly when compared to countries like the UK with a base rate set at 0.5%.

When the gap closes that advantage is eaten away and the currency of the country with the declining interest rate advantage also declines.

Hence, we have seen the New Zealand dollar lose ground through 2015 on three interest rate cuts at the RBNZ.

No More Interest Rate Cuts?

The trend lower in the kiwi dollar has continued in anticipation of further interest rate cuts.

However, that trend could stall and even reverse if markets get the message that no further rate cuts are likely.

Step in the RBNZ Governor Graeme Wheeler who on the 14th of October gave a strong hint that no further interest rate rises were coming.

The Governor said further rate cuts must be constrained on two observations:

(1) there is little evidence that reducing rates further will boost growth and, in turn, inflation and 
(2) further rate cuts risk pouring more fuel on an already blazing housing market.

In an important development for the Kiwi the RBNZ also reaffirmed its September MPS news that it is becoming more relaxed about getting CPI inflation within the target band and less focused on hitting the 2.0% mid-point.

“Trying to raise inflation by cutting interest rates in this environment is like pushing on a piece of string – highly unproductive. Consequently, and rightfully in our opinion, Governor Wheeler is now saying lets treat this target more flexibly both in terms of the levels we are aiming for and the time it might take to get there,” says Stephen Toplis at BNZ.

The message will certainly have economists pencilling in changes to their New Zealand dollar forecast profile, and the odds favour the majority of any changes pricing in a stronger NZD.

While most forecasts presently see a weaker New Zealand dollar in 2016 the upgrades will likely mean the floor will be higher.

Having put the recent developments at the RBNZ together, BNZ say they feel more comfortable that, after one more rate cut this year, the RBNZ will pause to survey the landscape.

“The balance of risks will still favour further interest reduction thereafter but the perceived hurdles to doing so have just got higher,” says Toplis.