We are now less bearish on the New Zealand dollar (NZD) as we expect the Reserve Bank of New Zealand (RBNZ) to raise the cash rate by 100bp to 3.5% in 2014 compared to our earlier expectations of 50bp hike. This is due to stronger than expected economic growth and a more hawkish RBNZ monetary policy outlook. Our NZD/USD forecasts in 2014 and 2015 have been revised higher to 0.78 (from 0.76) and 0.76 (from 0.72) respectively. The NZD outperformance against the Australian dollar (AUD) is expected to continue, though the trend against the Canadian dollar (CAD) is likely to fade as the latter benefits from a stronger US economy.
Less bearish view on the NZD
We are now less bearish on the NZD as we have revised up our interest rate expectations for 2014. We now expect the RBNZ to hike the cash rate by 25bp in March 2014 followed by another 75bp during the course of this year. The RBNZ is expected to follow up with another 100bp of rate hikes in 2015. Our 2014 and 2015 NZD/USD forecasts have been revised higher to 0.78 (from 0.76) and 0.76 (0.72) respectively. As a result we have removed the NZD from our high conviction currencies to short list given our more gradual depreciation expectations in the NZD against the US dollar (USD) and higher negative carry (due to higher cash rate expectations).
Growth returning to trend rate
High commodity export prices, low interest rates, momentum in the housing market and continued reconstruction in Canterbury have supported economic growth in New Zealand in the past year. Economic growth expanded by 3.5% yoy in the third quarter of 2013, higher than market expectation and the RBNZ’s estimate of 3.3%. Looking ahead, we expect growth to average around trend rate of 3% this year before moderating in 2015 as tighter monetary policy in 2014 cools the economy.
RBNZ has become more hawkish
Though the RBNZ continues to expect the strong NZD and fiscal consolidation to weigh on economic activity, stronger than projected export commodity prices and house price inflation have increased their monetary policy tightening bias as stated in the December monetary policy statement. Macro prudential tools implemented on 1 October 2013 to cool the housing market have shown some encouraging results as expected and is estimated to subtract 1 to 4 percentage points from house price inflation in the first year of implementation with diminishing effects thereafter.
However with non-tradables inflation rising to the highest level since the cash rate was cut from 3% to 2.5% in early 2011 and the strong currency’s disinflationary impact on tradables inflation easing, the current accommodative monetary policy is deemed no longer necessary.
NZD underperformance against the USD is still likely
The NZD has been resilient against the USD, declining by less than 1% in 2013 due to stronger than expected economic data releases and expectations of tighter monetary policy in 2014. The NZD is still expected to depreciate against the USD over the next two years for several reasons. First, based on purchasing power parity, the NZD is overvalued by more than 25% against the USD. Second, the market has priced in more than 20bp of rate hikes this year than we currently envisage. Third, the terms of trade is expected to moderate gradually as dairy prices ease lower due to a recovery in global supply. Fourth, we are more optimistic on US growth and pace of Fed rate hikes in 2015 than market expectations.
NZD outperformance against the AUD to continue though likely to fade against the CAD
The transition of China’s economic growth model from being investment led to one more focused on domestic consumption is expected to benefit New Zealand’s export products at the expense of Australia’s key commodity exports like iron ore. Along with divergence in monetary policies between Australia and New Zealand, the AUD underperformance against the NZD is expected to persist with the AUD/NZD cross retesting the 1.05 level, last seen in 2005. Though the NZD boasts higher real returns than the CAD, the latter is expected to be supported as Canada’s exports benefit more from a stronger US economy in the coming years. On the other hand, New Zealand’s exports are likely to be impacted as economic growth in their second largest export market China slows to 7% in 2015. Last but not least, non-commercial futures short positions in the CAD are near extreme levels and hence a short covering in the CAD should support the CAD relative to the NZD.
Remain short AUD and CAD versus the USD
We maintain our view that both the AUD and CAD will continue their underperformance against the USD in the following two years for several reasons. First we expect growth in Australia and Canada to remain below the trend rate this year and monetary policy to remain accommodative. In fact we believe the Reserve Bank of Australia is still likely to cut the cash rate by another 25bp to bring the cash to 2.25% as the mining investment cliff materialise this year. Second, the AUD and CAD are overvalued against the USD by about 20% and 10%, respectively. Last but not least, given our above market consensus view on the US economy, we expect the market to gradually price in a sharper pace of Fed rate hike expectations in 2015 (1.5% by the end of next year versus current market pricing of 1.1%). Our 2014 and 2015 AUD/USD and USD/CAD forecasts are 0.85, 0.80 and 1.08,1.12.