fxmatters

The deadlock is still not broken. The NZD/AUD at 79.8c is near midway of the 75.5 – 83.7 range of the last 18 months. The NZD/USD at 73.3c is above the midpoint of the last 12 months but remains within the 65.5 – 76.3 12-month range. Providing some upward pressure on the NZD/USD is the gradual recovery of the EUR/USD, and the coincident recovery of the US share market, more so due to the likelihood of prolonged low US interest rates rather than any harbingers of global growth. Therein lies the problem: the global outlook remains fragile; or, as the Bank of Canada put it, “the global economic recovery is proceeding but is not yet self-sustaining”. This is probably not enough to force another US easing this week but that is the direction of risk. Meanwhile the RBA is very much on hold, having attained average interest rates to borrowers, while the RBNZ appear reluctant to return NZ borrowing rates to average too rapidly due to weak local spending. There appears little ahead to break the deadlock while the risk of a sharp US share price fall – and hence NZD fall – remains high.

The stalemate continues. The general expectation is for global and local growth ahead but there is also awareness of the risks that abound. Some of these risks come into focus this week: US corporate earnings stream through from now for the June quarter; and June quarter Chinese GDP will also be reported. Growth in both areas has slowed, but by how much is yet to be revealed. Markets appear to be anticipating the worst at present. This sentiment – and the risk of confirmation – signals that a sharp NZD fall could occur at any stage. However the more likely scenario is that range trading persists. Picking the shifts within the range is a guessing game but with local spending constrained, with the RBA now on hold and with the European banks about to reveal their balance sheet strength – or lack of – next week the short-term risks appear biased towards a lower NZD/USD as well.

Putting aside the NZD for a moment, the following notes – in response to a query – look more generally at interest rate trends at present, and sources of information.

• RBNZ raises Official Cash Rate (OCR) from 2.5% p.a. to 2.75% p.a., the first tightening move since the drop in 30-Apr-09. Wholesale interest rates changed only slightly, an example of markets anticipating an announcement – see ASB report. The market is anticipating the RBNZ to steadily raise the OCR in the months ahead, putting short-term wholesale interest rates around 1.5% higher in 12 months – see graph of futures pricing.
• Retail interest rates have not as yet moved in response to the tightening but an adjustment in the Variable Home Loan Rate typically follows an OCR move (see ASB Home Loan Rate Report for wider view of mortgage rates and Good Returns for a comparison across financial institutions). The confirmation of the tightening phase should also see bank bill yields and short-dated Term Deposit rates trend higher, some of which is already happening (e.g. 6-month rates).
• The general movement of interest rates and exchange rates over the week demonstrated the interaction – often mixed – of international and local forces. The 2-year swap rate actually declined Friday-to-Friday (see Westpac Morning Report), any small surprise element in the RBNZ announcement offset by a more general decline in global interest rates over the 7 days (that spanned the weaker-than-expected US jobs report). New Zealand longer-term rates tend to follow US rates, as do many other countries, with the premium on NZ 2-year government yields centring on 3% recently.
• Conversely, the NZD rallied in response to the RBNZ announcement as well as before and after Thursday, the small local surprise element working in concert with the global shift to risky assets (that includes the NZD and AUD).

We come around once more to the monthly US jobs data. In fact we are moving into a period where news in several places have the potential to surprise (e.g. US data, RBA meeting and data, G20 finance ministers meeting next weekend, RBNZ meeting next week) – see calendar). But first the US labour market: the jobs growth in April was the largest since March 2006. The May growth will be a lot more, partly the result of temporary employment on the US Census, but maybe also enough to nudge the US unemployment rate a little further below 10%. Significantly, further evidence of a turnaround in the US jobs market will be the trigger for the US Fed to step up the tightening process and herald a period of US strength. The euro is already coming under pressure and strong US data would likely tip the balance further. Meanwhile in Australia the RBA are likely to refrain from another rate hike Tuesday, taking some of the sting out of the AUD as well. This mix of forces increases the odds that the NZD/USD stays around the mid 60s – or lower – having recently broken below the range of the previous six months.

The Goldilocks period continues. News of improving economies continues but it is not coming quick enough to force higher interest rates in the major economies. The result is share prices and other risky assets show a slight upward bias. And the NZD/USD does not fall.

There is some monetary tightening occurring. Singapore this week revalued the Singapore dollar after news of strong March quarter growth. And the RBA raised their cash rate again last week. Both factors are providing upward pressure on the NZD/USD.

These forces could see the NZD/USD run up towards the 2010 peak of 74.4c but they do not appear sufficient to drive the NZD out of the recent trading range. The most likely circuit-breaker still appears the prospect of higher US interest rates, and hence a higher USD (and lower NZD/USD). In the meantime, range trading persists.

Every now and then events come along that can significantly change markets. The US jobs report this Friday is such an event. A pivotal moment in the recovery will be when US employment increases and unemployment decreases. The US March job growth to be released Saturday morning (NZ time) – during a holiday in many parts of the world – could be strong coming after blizzards and recession and during a temporary Census employment boost. A big number (e.g. 400,000 or more new jobs) is likely to push the USD upward, and hence the NZD/USD downward, possibly sharply on the night. Nothing is certain with the future but this is one event where importers should seek cover and exporters sit back.

At the margin, the economic data of late are on balance positive, indicating growth here and generally abroad. This is promising. The NZ GDP release Thursday is expected to fit into this category. But the risks remain unusually high. There are numerous global examples of business failures, job losses and debt refinancing problems. There are mounting tensions e.g. within the Eurozone and between China and the US. All set against a backdrop where expectations in equity and commodity markets are relatively high, and where monetary and fiscal tightening is yet to occur.

The challenge for traders and investors is whether to focus on the gradual improvements or on the risks that still lie ahead? The answer will vary by each individual’s situation.

For me, the number of things that could derail the equity market rally appear too many. And if the equity market falters, so too will the NZ dollar.

A noteworthy risk was highlighted Friday, namely monetary tightening in Asia. There is more to come. A surprise monetary tightening by the Bank of India is of little global importance. Further tightening by China, including (gradual) CNY appreciation again, is another matter. Such an initiative is becoming more probable during April/May. And a Chinese tightening does hold the potential to shake confidence in the equity markets and drive the NZD/USD below its recent 68c floor.

The RBNZ have confirmed their expectation of a mid-2010 rate hike. However it is the US Fed’s initial tightening that will probably determine currency trends. The Federal Open Market Committee meet this week (result Wednesday morning NZ time). It is too soon to tighten yet but that could change quickly. At the start of the previous cycle in 2004 the Fed went from “accommodation can be maintained for a considerable period” to a rate hike within 6 months. A key trigger in the process was US employment growth over March-May. During this spell the USD rallied around 10% and the NZD/USD experienced a drop from around 70c to 60c.

At present, leading indicators suggest US job growth is imminent. If jobs do emerge, the Fed will quickly drop the current “warrant exceptionally low levels of the federal funds rate for an extended period” and soon after raise the overnight rate from its near-zero level. A USD rally (and share market fall) will occur and the NZD/USD would depreciate.

But recall, the USD was falling and US share prices were rising before 2004 was out. It was in the lead-up to the Jun-04 Fed tightening and during the early stages that the USD was favoured and the NZD was under pressure.

It may be too early for the Fed to signal a change this week but a re-run of 2004 is likely at some stage soon.

This week the focus shifts to the RBNZ. Add the likelihood that the RBNZ will repeat its call for a mid 2010 tightening to the global share market rally and the RBA rate hike of last week and the scene is set for the NZD/USD to rally this week.

In broad terms the economy is evolving as the RBNZ outlined in the December Monetary Policy Statement, albeit with the upside growth risks now less. There is much to be uncertain about at present including near-term global growth prospects, the impact of local liquidity requirements for banks that come into force 1 April and the policy measures to be unveiled in the 20-May Budget. Nonetheless the local growth rate is now higher and, significantly, the Australian economy is strengthening.

Meanwhile the cash rate is at unsustainably low levels. The appropriate policy path is to continue warning of imminent cash rate hikes but allow scope for reaction to the April/May policy intitaives; hence the likelihood that the RBNZ repeats the vague “begin removing policy stimulus around the middle of 2010″ line on Thursday.

Any NZ dollar reaction this week is unlikely to change the broader picture of a sideways trading NZD/USD with the probability of a revisit to 65c still high.

One of the largest risks this year is of further credit-related issues. It is this factor that will likely see the NZD/USD revisit 65c in the next few months.

However we are also amidst a large mining boom in Australia, in turn the result of strong emerging economy growth – as discussed by the RBA last week [speech]. Of particular interest is the RBA’s expectation of higher terms of trade to come for Australia [given earlier in the month]. This would normally mean an upward bias to the Australian dollar.

History suggests that the risk cycle will win out in the short-term (i.e. over days/weeks) but, short of the major reversal in China, that the mining boom will probably dictate the AUD trend over the next 2-3 years.

One of the ways that these mixed influences have manifested recently is to push the AUD/EUR towards highs even while the AUD/USD has been slipping lower.

A similar pattern is noticeable with the NZD. The NZD/EUR does swing with shifts in the USD but the medium-term drift is upward (due largely to the AUD influence). Looking forward, the expected USD rally will likely see the NZD/EUR lower in the next few months but new highs for this cross-rate are still probable later this year.