Market Insight – Foreign Exchange – Kiwi strength sustainable?

Surprise cut fails to halt NZD rally

On March 10th the Reserve Bank of New Zealand (RBNZ) surprised markets with a 25bp interest rate cut, citing international weakness and falling inflation expectations as key drivers. Even with the element of surprise, the move failed to halt the NZD’s recent rally, with the currency appreciating a further 2.1%* in the following fortnight on a trade weighted basis, contributing to a broader 5.8%* rise over the past seven months. The NZD has been a key beneficiary of improving risk sentiment and growing demand for high-yielding assets; with its domestic government bonds offering the best return of the G10 currency group (see Figure 1). However, the NZD/USD currency pair is approaching the peak of its recent trading range and the RBNZ appears likely to implement further monetary easing measures at its upcoming meetings; factors which, in the short term, may see the NZD correct lower.

Figure 1

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Falling inflation expectations arouses concern

The recent strength of the NZD has surpassed the expectations of the RBNZ by some margin (with the trade weighted exchange rate sitting 4% higher than December projections) and is exacerbating central bank concern that falling inflation could embed itself in expectations. The latest monetary report revealed that results from business and consumer surveys monitored by the RBNZ indicate that inflation expectations have experienced a “material decline” in recent months (Figure 2); stoking fears that weakness could feed through to wage setting negotiations and trigger a deflationary spiral.

At the press conference following the monetary policy announcement, the RBNZ Deputy Governor identified the deterioration in inflation expectations as the “primary motive” behind the decision to cut rates in March. These concerns increase the importance of Q1 inflation numbers due on April 17th, as a poor reading will increase the likelihood of further interest rate cuts at the RBNZ’s upcoming meetings, which will likely place the NZD under pressure.

Figure 2

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Top of recent range

A combination of dovish commentary from Federal Reserve Chair, Janet Yellen, and NZD strength has pushed the NZD/USD currency pair to the higher end of its recent trading range. From a technical perspective, since falling through the 0.69 level in June of last year the NZD/USD has struggled to breach this level for a prolonged period and so further gains to the upside appear unlikely.

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