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NZD/USD Q4 Outlook

Friday, 13 October 2006 21:05:30 GMT  |  DailyFX Research Team

After having sold off significantly in the beginning of the year, the third quarter has proven to be extremely positive for the New Zealand dollar.

NZD/USD Outlook

 

After having sold off significantly in the beginning of the year, the third quarter has proven to be extremely positive for the New Zealand dollar.  The currency has rallied over 10 percent against the US dollar since the beginning of the quarter as the country’s high yield continued to attract foreign investment, increasing demand for the underlying currency. Despite the strain that the high interest rates are beginning to have on the economy, the Reserve Bank of New Zealand has insisted that they will not cut interest rates as inflation remains stubbornly high.  This resurrected the carry trade for many macro funds and investors who were interested in earning higher rates of return at the expense of the Japanese Yen and the US dollar, whose respective central banks have signaled the intention to leave interest rates unchanged for some time. 

 

Yield, Yield, Yield

 

New Zealand interest rates are currently at 7.25 percent, the highest of the industrialized nations.  Such a strong rate of return has long been too attractive for international investors to ignore, but the last time that the central bank raised interest rates was back in December.  As the year progressed, the potential slowdown in global growth and slide in soft commodity prices prompted the market to believe that the Reserve Bank of New Zealand would consider cutting interest rates which led to a steep slide in the New Zealand dollar.  However, in September, RBNZ Governor Bollard completely reversed the market’s sentiment and caught traders by surprise when he said that persistent inflationary pressures makes it possible for the central bank to consider raising interest rates again in this business cycle.  A strong housing market, decent consumer demand and rising oil prices has pushed consumer prices in New Zealand to 4 percent, beyond levels that policy makers had previously estimated.  The RBNZ’s inflation target is between 1 to 3 percent, which means that given 4 percent inflation levels, they do not have the flexibility to drop interest rates, otherwise they would risk pushing inflation to even higher levels.  With no downside risk to yield, foreign investors were quick to jump back into the long Kiwi carry trade.

 

Strong Currency Hurts Economy

 

However, the higher the New Zealand dollar goes, the more dangerous it is for the economy.  As an export dependent nation, New Zealand has already seen its trade balance suffer as a result.  In the month of August, New Zealand’s deficit jumped from NZD703 billion to NZD961 billion. The strong kiwi has boosted imports and decreased exports. With higher growth in the Pacific region, consumers in New Zealand are clamoring for imports, far outpacing the number of exports leaving the country, sparking concerns over the consequences of a wider trade deficit.  Running at a pace of 9.3 percent of the economy’s gross domestic product, the widening deficit has sparked investment concern as it continually erodes at expansion.  With the shortfall lingering, market participants continue to remember the effects of the potential downgrade that was warned by Standard and Poor’s, the rating agency, earlier in the year.  With a wider deficit leading to questionable growth, the credit agency warned of a downgrade to the economy’s credit rating, which could increase New Zealand’s debt payments as well as cause a mass exodus out of New Zealand dollar investments as some funds are only allowed to invest in the countries with the highest credit ratings. 

 

No Changes Expected from RBNZ

 

The potential for worsening the deficit is a strong reason why the RBNZ may not actually follow through with raising interest rates, even though the last time Bollard spoke, he leaned closer to that camp.  The economy is beginning to feel the pain of a strong currency.  Business sentiment fell in the month of September from 52.3 to 50.5 according to the ANZ Business sentiment index.  GDP also grew by the slowest pace in five years in the quarter ending in June.  The most recent consumer spending report indicated that after three consecutive quarters of increased spending, retail sales stalled in the month of August.  Back in September, the other reason why RBNZ Governor Bollard was looking to raise rates besides inflation was because consumer spending did not slow as much as he had expected.  Now that we are seeing a sign of slowing, the central bank may step away from their slightly hawkish stance.   Inflationary pressures are also subsiding globally thanks to the slide in oil prices.  New Zealand should see that reflected in their inflation reports in the months to come.  Therefore at this point, the RBNZ is most likely going to leave interest rates unchanged for the remainder of the year.

 

Government Gets Antsy

 

However, keeping the gains capped in the near term, and weighing on the market even at the current moment, are comments issued by Finance Minister Michael Cullen.  Talking down the currency, Minister Cullen has been warning of an overvalued Kiwi dollar for some time now and continues to add to pressure by “clarifying” bullish statements by policy officials.  Most recently, the Finance Minister has gone so far as to warn speculators of a considerable drop in the underlying currency to as low as 40 cents since further monetary tightening is not assured at this point.  Additionally, Cullen spoke to Parliament stating “it is incumbent upon me as Minister of Finance” to rectify such misinterpretations like hawkish comments made by Reserve Bank of New Zealand Governor Bollard.  Should the jawboning by one of the key policy officials continue, appreciation in the Kiwi dollar may be limited. 

 

Conclusion

 

With interest rates remaining high, the New Zealand dollar should continue to be in demand.  However, slower economic data and falling inflationary pressures should align RBNZ Governor Bollard closer to Finance Minister Cullen.  Cullen has been actively telling the markets that the New Zealand dollar should be weaker.  If consumer spending does not pick up and the trade deficit remains high, the central bank governor has no reason to counteract Cullen’s calls.  The New Zealand dollar is already showing signs of topping out, but a meaningful reversal may not occur until we hear a clear shift in stance from Governor Bollard.  The risk is greater to the downside at the moment.  If the deficit does not reverse anytime soon, we could also hear further warnings from rating agencies which will cap further gains in the Kiwi dollar. 

 

Technical Outlook

 

We mentioned last quarter that “the Fibonacci relationships within the waves of the .7462-.5927 downtrend increase the likelihood that .5927 was an important low.”  The Kiwi rallied to the confluence of the 50% fibo of .7462-.5927 / 61.8% fibo of .7197-.5927 at .6695/.6710 (the pair topped out at .6721) on 9/26.  This resistance zone is reinforced by the7/8/2005 and 12/23/2005 lows at .6683 and .6700.  Also, the September candle on the monthly chart was a long doji reversal candle.  The reference point to watch in this pair is the 3 ½ month trendline drawn through .5927 and .6342.  That line is currently at .6532 and increases about 8 pips per day.  A break below would likely attract heavy selling and eventual tests of support at the 9/11 low (.6342), the 7/18 high (.6206) and finally the 6/28 low (.5927).  A push above the aforementioned wall of resistance between .6680 and .6720 exposes the 61.8% of .7462-.5927 at .6875.

 

NZD/USD Weekly Chart (Source: FXTrek Intellicharts)

 

NZD/USD Positioning

 

While we do not have much data regarding NZD futures, the number of long contracts reached its all time high on 8/15 and traders remained long Kiwi about 13,000 contracts until just recently.  In fact, from 9/26 to 10/3, the number of long contracts fell from 13,141 to 8,391 – a 36% drop.  Such a large drop often leads to a protracted decline in the corresponding commodity

 

 

 

 

 

 

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