NZ Dollar Strength Presents RBNZ with a Rate Cut Dilemma

NZ Dollar Strength Presents RBNZ with a Rate Cut Dilemma

26 April 2016, 20:00
Vasilii Apostolidi
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Viraj Patel, Foreign Exchange Strategist on why the New Zealand dollar’s strength is unlikely to trigger a response from the RBNZ this week.

  • Constructive risk environment is providing artificial support for the NZD
  • Likelihood of any explicit reference to FX intervention in the statement is lo
  • Age-old problem of NZD strength in a carry-friendly market is presenting a policy dilemma.
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The Reserve Bank of New Zealand (RBNZ) meets on the 28th of April and markets are split on whether an interest rate cut will be delivered.

Recall the surprise cut last month? The move was a surprise and has reminded markets that this is a Bank that does not care much for meeting expectations.

Quite rightly, any impact is best achieved by surprising when it comes to central banks.

However, some will view that fact that markets are pricing a 40-50% chance of another interest rate cut below 2.25% as strange as economic data is moving in the right direction and suggests previous rate cuts are working:

(1) Inflation has risen, 4Q15 GDP surprised to the upside 
(2) New Zealand’s terms of trade are improving with dairy prices recovering 6% in April 
(3) Greater stability in global financial markets

There is also the added concern that house prices continue to rise at break-neck speed, up 10% in March and the RBNZ risks adding fuel to an already red-hot housing market.

We have noted before that the RBNZ may be prompted into altering lending rules and expand existing restrictions beyond Aukland. Such a move would be a dead-cert sign that that the RBNZ is laying the groundwork for aggressive interest rate cuts.

NZD Strength Poses a dilemma for the RBNZ

With data heading in the right direction, and house prices heating up, why would the RBNZ want to cut rates?

The trade-weighted New Zealand dollar has rallied agressively since the turn of the year, as it does it pushes up the relative cost of New Zealand exports (such as the all-important dairy price) thereby acting as a drag on the economy.

Furthermore the NZD is likely to see this strength stick as global investors pour money into New Zealand to take advantage of high interest rates in a phenomenon known as the carry trade.

“We note that a more buoyant and stable risk environment has seen carry trades come back in fashion; in this regard, New Zealand’s high-quality and high-yield status is an attractive proposition for investors in a low conviction market,” says Viraj Patel, a Foreign Exchange Strategist with ING in London.

Patel suspects that the RBNZ will be concerned over the nature of the kiwi rally and with the OIS market pricing in a 40% chance of a cut this week, imminent easing may be necessary to deter speculative NZD inflows.

ING note that the chance of a rate cut happening this week will be a close call, but argue that further easing at some point is inevitable.

“While the odds of a second successive OCR cut hang in the balance, we still see sufficient arguments for additional easing in 2016,” says Patel, “while we are swaying towards thinking that the RBNZ will hold fire for now (ie, saving their ammunition for more testing times), we continue to look for a June rate cut in the absence of any improvement in the inflation outlook.”

Recall that the RBNZ have signalled two further rate cuts over a 12M horizon via their forward interest rate projections in the MPS.

Will the RBNZ Threaten FX Intervention to Stem NZD Upside?

ING reckon that any cuts to the 2.25% OCR are likely to be ineffective in foiling NZD strength in the current risk-on market.

Therefore thoughts of FX intervention may well be on the minds of policymakers.

“Historically, the bank has discreetly intervened in currency markets and then disclosed this information via their monthly FX reserve holdings data,” notes Patel, “Hence, the likelihood of any explicit reference to FX intervention in the statement is low.”

(Watch out for the next release of reserves data due 28 Apr).

Moreover, there may be a sense that “leaning-against-the wind” interventions could also prove futile in the current market setting.

Thus, ING feel that aggressive jawboning will remain the go-to option to deal with a strong NZD.

What Does this Mean for the Exchange Rate?

Risk-reward considerations see ING strategists prefering to fade NZD upside on the back of a rate cut disappointment this week.

“A constructive risk environment is providing artificial support for the NZD, with a dovish RBNZ playing second fiddle,” says Patel.

This is best depicted in AUD/NZD; 1Y swap rate spreads have moved 10bp in favour of a higher AUD/NZD after last month’s surprise RBNZ cut, yet the pair has traded sideways over the period.

Staying long AUD/NZD is still a preferred short-term tactical play for Patel, but he is wary that the RBA could turn dovish in 2H16, thereby undermining the recent strength seen in the AUD.

Given a currency-sensitive RBNZ and signs of overstated USD weakness, “we prefer to stay short NZD/USD – noting that the pair remains particularly vulnerable to a rebound in US data,” says Patel. 

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