nzd fundamentals

2007 Second Quarter FX Outlook

Tuesday, 10 April 2007 21:08:49 GMT  |  Daily FX Research Team

NZD/USD Outlook
The New Zealand dollar spent most of the first quarter range bound between 71 cents and 67 cents but  the final few weeks may have signaled the beginning of a new uptrend as the currency broke out to a new two-year high against its US counterpart.

This move was facilitated by a consistently hawkish monetary policy, a somewhat surprising interest rate hike and improving data for a number of key economic indicators. Looking ahead, many of the same drivers that were present in the first quarter of 2007 will continue to guide the kiwi in the months to come. Interest rates will certainly be a hot button issue as local business leaders and lower income consumers will be pitted against hawkish New Zealand central bankers who focus their attention on inflation rather than growth. Reserve Bank of New Zealand Governor Alan Bollard has already promised to pursue further rate hikes if the economy does not cool, and his steadfastness could drive the currency even higher. However, the most important issue facing the kiwi may not come from within the nation’s boarders. If volatility across global financial markets continues to rise and risk aversion takes hold in global capital markets, of the attraction of the lucrative carry trade may wane, leaving the currency in a very vulnerable position.

Record Interest Rates
The single most important event to impact the New Zealand dollar in the opening months of the year was the central bank’s decision to raise the nation’s overnight cash rate 25 basis points to a record 7.50 percent. The RBNZ was clearly adding tinsel to the kiwi’s crown when the nearest interest rate among the majors was Australia’s 6.25 percent benchmark yield. However, the decision was not made on a whim, but instead came after fair and deliberate warning and a series of strong fundamental indicators that laid out the need for such a move. Since the previous rate hike in December of 2005, RBNZ Governor Bollard continuously warned politicians and the investment community that he would follow through with his duty to bring consumer inflation back within the 2 to 3 percent tolerance band. As quarter after quarter passed with little sign of inflation abating, the central banker kept his language and intentions transparent. And though annual inflation has finally pulled back within the designated target band since then, the rhetoric remains as aggressive as ever. After the controversial March 8th decision to raise rates, Bollard said that “depending on the persistence of the current upturn, further tightening may be required.” More explicitly, he actually spelled out the ingredients needed for a change from hawkish to neutral and perhaps even dovish sentiment – a clear deceleration in housing and domestic demand. Both sectors of the economy continue to record brisk growth, which if left unattended may push the economy into an inflationary spiral. Even price growth, which is now within the realm of tolerance, still posses a threat. The annual measurement of the government’s Consumer Price Index decelerated to 2.6 percent in the fourth quarter. On the other hand, the indicator’s heightened sensitivity to energy prices suggest the rebound in oil and gasoline prices in the opening months of 2007 poses a very real threat to stability.

From Recession Fears To Consumer Driven Growth
Though the central bank has erred on the side of caution in the past, seeking to cool inflation before it becomes a bigger problem, the next chance in interest rates will almost certainly be made on the basis of economic data. Only a few quarters ago, fears that the New Zealand economy was plunging into recession and that the nation’s top sovereign credit rating was in jeopardy were spreading like wild fire. However, the dampening effects of restrictive monetary policy were not filtering through to their intended targets. Consumer spending, which was increasingly being funded by credit and wage growth, continued to present problems for the RBNZ. Retail sales rose 1.8 percent in the fourth quarter and the more recent January number registered another 0.5 percent pick up from the month before. Looking ahead, domestic demand seems unlikely to fade anytime soon. The unemployment rate fell to 3.7 percent in the fourth quarter of last year, while labor wage costs grew 0.9 percent over the same period. In addition, the first quarter Westpac consumer confidence survey held well above its expansionary/contractionary cutoff. Housing presents Bollard with another problem as New Zealanders draw equity from their property and in turn use it to fuel discretionary spending. On the other hand, there are indicators that may jeopardize the growth scenario, namely those related to business and industry. When the central bank lifted rates in early March, it created a furor among firms who found it increasingly difficult to afford loans and adjust to unfavorable exchange rates.

Carry Trade Unwind, Carry Trade Return
Though the arguments of faster inflation and higher interest rates are fundamentally important; from the currency market’s perspective, they are simply the means for the carry trade. Everything else being equal, investors would flock to the high yielding currency. However, free markets do not occur in a vacuum and turbulence is always on the horizon. An important factor of the carry trade (one that is arguably as important as the yield spread itself) is the need for a low volatility environment. High volatility raises uncertainty and increases the risk of capital losses that negate the benefits of interest collection. Such a scenario played out in the beginning of March when global market participants suddenly transferred their assets from high return to less risky investments. In this mass exodus from risk, many currency traders dumped high yielding currencies like the kiwi in favor of cheap, low interest paying ones like the Japanese yen and Swiss franc. Whether or not such a shift is necessarily safer is debatable; but regardless, it helped alleviate some of the over-bought sentiment in the carry trade. And, this short break may have been all the market needed for fresh bids to come back to the kiwi. Since the pull back, pairs like NZDJPY and NZDCHF have rallied back to their previous highs. However, despite the carry trade’s return, the risks are even greater for another quick and violent unwinding. With overall volatility in the market elevated and kiwi traders extra cautious after the previous flight from the high yield currencies, it may not take much to trigger a second wave of liquidation.

Conclusion

The New Zealand dollar does not have the deep liquidity of the US dollar or the euro. Instead, the kiwi’s appeal relies on its very high benchmark rate. At 7.50 percent, few advanced economy currencies can beat the New Zealand dollar for yield. On the other hand, the threat of a broad economic slowdown looms as the nation’s business sector is weighed down by the same high interest rate that has boosted the currency. This in turn has lead many to believe the stalemate between inflation and growth will keep the central bank on hold for another extended period. However if the RBNZ holds the overnight cash rate at its record high (even with lingering threats of another boost for good measure) the yield in the funding currencies may continue to rise and therefore compress the differential with the kiwi. More importantly, investors may simply realize passively collecting the carry is too risky in a world of rising volatility. All of these issues will play a role in the New Zealand dollar’s direction presenting traders with both risks and opportunities in the months ahead.

Technical NZD/USD Outlook
Kiwi traced out a 5 wave decline from the early 1970’s (1.4900) to October 2001 (.3897).  A 5 wave advance followed to the March 2005 high of .7463 in what was most likely the A wave of an even larger A-B-C advance to correct the 1.4900-.3897 decline.  The decline from .7463 to .5927 was either the B or just the first part of the B wave.  A break above .7463 would indicate the former and place NZDUSD in a C wave that is headed much higher (A would equal C at .9493) over the next several years.  However, given the extremely bullish sentiment readings recently (long positions have accounted for over 90% of speculative positioning since August 2006), we are looking for a decline towards at least the 4th wave of one less degree at .7082.  The risk reversal rate on 1 month options is the highest since December 2004 (Kiwi reversed at .7274 and traded to .6902 5 weeks later).  There is an interesting time relationship as well.  The rally from the May 2004 bottom to the March 2005 high lasted 44 weeks.  The decline from the March 2005 high to the June 2006 low lasted 68 weeks.  The rally from the June 2006 low has lasted 41 weeks (41st week ended on April 6th).  Kiwi may be exhibiting a longer term rhythm with the 40-odd week rallies but the long term rallies and declines are also in Fibonacci proportion regarding time as  42/68 = .618.  A decline below .6718 indicates additional bearish potential.               

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