FX comment – NZD rebounds after the RBNZ projects stronger economic growth

by: Roy Teo

  • RBNZ kept the OCR unchanged at 3.5%; upgrades economic outlook
  • Monetary policy tightening delayed
  • Softer tone on the strong NZD…
  • …overvalued NZD to decline

RBNZ kept the OCR unchanged at 3.5%; upgrades economic outlook

The New Zealand dollar (NZD) surged by more than a cent to above 0.73 early this morning after the Reserve Bank of New Zealand (RBNZ) upgraded its economic growth projections over the next two years. Low interest rates, increasing house prices, strong household income growth and fall in oil prices are supporting consumption and investment growth. Nevertheless there are several factors weighing on domestic growth, including drought conditions in parts of the country, fiscal consolidation, reduced dairy incomes and the strong exchange rate.

Monetary policy tightening delayed

The RBNZ noted that as monetary policy affects inflation with a lag and cannot offset the effects of lower oil prices, policy focus should be on the medium term trend in inflation. Inflation is expected to fall to around zero in the first quarter of this year and remain low over the remaining quarters. This is due to the strong exchange rate, low global inflation and decline in petrol prices. The central bank now forecasts inflation to reach 2% only in the third quarter of 2017 compared to previous assessment of last quarter of 2016. As such, we now expect monetary policy to remain unchanged at 3.5% over the next two years, compared to previous forecast of 75bp increase in 2016.

Softer tone on the strong exchange rate…

With regards to the NZD, the RBNZ reiterated that the NZD remains unjustifiably high and unsustainable on a trade weighted basis (TWI). A substantial downward correction in the exchange rate is needed to put New Zealand’s external accounts on a more sustainable footing. In our view, this is a softer tone compared to the previous statement in January this year “We expect to see a further significant depreciation in the exchange rate.” The central bank has also projected a slower pace of depreciation (slightly over 1%) in the NZD against its trade weighted basket of currencies by the end of 2016, compared to almost 5% in the last assessment in December 2014. This is due to changes in the definition of the NZD TWI and the starting point for the TWI to be slightly lower than assumed in the previous assessment in December last year.

…overvalued NZD to decline

We maintain our view that the NZD will decline towards 0.68 and 0.64 by the end of 2015 and 2016 for the following reasons. First, our view that monetary policy in New Zealand will remain unchanged over the next two years is not materially different from what is priced in by financial markets. Second, the NZD remains the most overvalued currency among G10 currencies. Third, interest rate differentials between New Zealand and the US is expected to narrow as the Fed tightens monetary policy over the next two years. This will reduce the carry attractiveness of the NZD. Last but not least, financial markets are significantly under-estimating the magnitude of rate hikes in the US in our view.