Central Bank Sparks Renewed New Zealand Dollar Demand

How Did The Markets React?

The Reserve Bank of New Zealand surprised markets through its interest rate announcement, leaving the Overnight Cash Rate at 7.25 percent but hinting that the next rate move would likely be a hike. As often occurs with fundamental data releases, markets posted a knee-jerk reaction to the headline number, only to reverse course when the full implications of the news became clear. The charts below will show that the New Zealand Dollar and domestic Interest Rate Futures implied LIBOR both plummeted as the central bank left rates unchanged, but the overtly hawkish rhetoric made such declines very short-lived. Given recently soft inflation figures and signs of slowing consumer demand, traders fully expected that RBNZ Governor Alan Bollard would err on the side of dovishness in his outlook for inflation and monetary policy. Instead, the head central banker cited concerns about “the upside risks to medium-term inflation”; previous predictions of a slowing housing market and consumer spending are “looking more uncertain”. To clearly tip expectations in favor of a near-term rate hike, Bollard concluded his statement by saying, “In the absence of clear indications of a moderation in housing and domestic demand, it is likely that further policy tightening will be required.” Currency traders immediately bid the Kiwi higher, leaving fixed income assets lower, while domestic equities stayed relatively unchanged through the news.

Bonds – New Zealand 3-Month Interest Rate Futures

New Zealand interest rate futures posted dramatic reactions to the central bank announcement, with a sharp rally quickly leading to larger decline. The March contract hit highs of 92.35 as rates were left at 7.25 percent, but a closer examination of the underlying report left it more than 10 points lower through time of writing. In doing so, the New Zealand Interest Rate Future now shows that traders have priced in a 100 percent chance of a 25 basis point interest rate hike through the first three months of the calendar year. This stands in stark contrast to price action that followed the most recent inflation report, as markets had clearly scaled back expectations of higher rates through the medium term. Now that the central bank has clearly signaled its hawkish bias, higher interest rates should only lend further support to the highly interest rate-sensitive New Zealand dollar.

FX – NZDUSD

For the currency market, the RBNZ’s rate decision caused wild fluctuations even though the policy board decided not to change the overnight cash rate - or its outlook for that matter. The action in the New Zealand dollar began a few moments before the governing body announced its verdict to the public. Well-funded traders looked to take advantage of the market conditions to create a quick swipe at an easy profit and potentially position themselves for a better entry price. Leading into the 20:00 GMT announcement, volatility dried up with liquidity. Under such conditions, a relatively large order could leverage a large reaction in the market. This allowed a series of sell orders to drive NZDUSD below 0.6950 and flush stops through the region. Initially, those traders that saw the shift in momentum or otherwise jumped on the official announcement of a pass joined the fray. However, astute traders knew the trade was not in the actual rate decision itself, but rather the commentary that accompanied it.

After last week’s weaker-than-expected inflation numbers, the divide between economists calling for a rate hike and those calling for a cut grew. In the moments after the release, there was a flood of users trying to access the RNBZ’s site in order to get a jump start on where the true direction would lead. Those who finally had the page load beheld an unexpected site – a completely reversed outlook. In the text, RBNZ Governor Alan Bollard noted the contraction in fourth quarter inflation numbers. Referring to the first quarterly contraction in consumer goods prices, Bollard projected a further drop in inflation. However, for 2008, the Governor predicted a strong resurgence. This forecast recalls comments he made December in which he saw a dip in annual CPI to 1.9 percent by September and a subsequent rebound to 2.7 percent by December.

More importantly, economic outlook for the economy improved further. Though the most recent data revealed the first drop in retail sales in seven months and sharp contraction in housing permits, Bollard was more concerned with the bigger trends. The housing market grew 19 percent through the year ending in December, while prices rose to record highs. For consumers the foundation for spending was even greater now that it was before. Fourth quarter consumer confidence grew the most in six years while unemployment held near its low at 3.8 percent. Also, further away on the horizon, yet blazing like a flare, is Finance Minister Michael Cullen’s plan to increase payments to family and cut taxes for companies before the 2008 elections. With the future of the carry firmly in place, the carry appeal of this currency looks to hang around for some time.

Equities – NZX 50 FF Index

The decision to keep interest rates unchanged by the Reserve Bank of New Zealand came only an hour before the official open of capital markets in the nation’s financial center. Allowing for the decision and associated comments to sink into the market’s psyche, equity traders had plenty of time to decide how the revisions to the policy outlook would effect their positions. After the bell rung, the bulls proved to be the more forceful group. Moments after the first traders were processed in the big-caps, the NZX 50 Index touched an all-time high. However, the trading day had only just begun by the time this was written. Investors have to decide how they will respond today and the days ahead to the threat of another rate hike. Since the last rate hike in December of 2005, RBNZ Governor Bollard has relentlessly paid lip service to the possibility of an additional 25 basis point lift in overnight lending rates; so traders are not easily frazzled by such potentiality. However, the passing on a rate hike this month seems to be an accomplishment in itself. Prior to the announcement, there was growing support for a possible rate hike. For those who protected themselves from such an event, the pass was a relief.

Another interesting facet of the meeting for the stock market was the components of the outlook. Though Bollard repeated his warning that the next hike would most likely be towards tightening, his projections for the economy and inflation in the medium term were rather promising for revenue growth. For inflation, the governor foresaw an easing in consumer prices through most of 2007, before rebounding late in the year and going into 2008. For consumers, the numbers were all good. Sentiment, housing and retail activity were all components of his bright outlook; but it was the Finance Minister’s suggestion of tax benefits and government payments to New Zealand families before the 2008 election that really caught the central bank’s eye. Spending would almost certainly increase after the beneficial policy took effect and could even encourage spending before the fact.