Article / 22 June 2016 at 1:58 GMT

Asymmetric risks for NZDUSD as Brexit vote looms

Managing Director / Technical Research Limited
New Zealand

  • NZ's current policy rate of 2.25% stands out in the global market place
  • Rising exchange rate is putting RBNZ's 2% inflation goal in jeopardy
  • If NZD doesn't start heading down RBNZ will have to drop inflation projections

By Max McKegg

The New Zealand dollar is proving to be an oasis of stability as markets await the Brexit vote. Early in the New York trading session NZDUSD hit a 12-month high at 0.7169 before backing off a touch as the US dollar regained its footing.

While historically NZDUSD has been a high beta cross, pushed and pulled by risk on/risk off sentiment, lately, in a world of sub-zero interest rates, it seems the attraction of the carry trade is keeping the Kiwi up, regardless. As such, for NZDUSD, the risks around the Brexit vote look to to asymmetric.

New Zealand is a minnow in the global economy but NZDUSD is a popular cross in FX markets, turning over in excess of $100 billion per day.

Sometimes domestic factors hold sway for a day or so but it’s the USD side of the cross that mostly sets the direction. Hence traders were listening closely to Federal Reserve chair Janet Yellen’s testimony before the US Senate a few hours ago.

While the tone of her prepared remarks was predictably practical some commentators noted a subtle change when she said that “proceeding cautiously in raising the federal funds rate will allow us to keep the monetary support to economic growth in place while we assess whether growth is returning to a moderate pace, whether the labor market will strengthen further, and whether inflation will continue to make progress toward our 2 percent objective”.

Previously the word “when” had been used in preference to “whether”. Does this suggest that for Yellen it's not a question of when the Fed will raise rates but whether it will do so at all ?

Whatever, the markets didn’t make much of it; in fact the odds of July rate hike firmed a touch, albeit to a still miniscule 10%.

 Kiwi inflation: The NZD is getting stronger no matter what the risk events. Photo:iStock

Suspicion that the US Federal Reserve’s rate hike path is moving from gradual to glacial makes traders warm to traditional carry trade favourites such as the Kiwi dollar.

In New Zealand, the domestic yield curve offers rates around 2.5% for an economy with a AA credit rating and projected GDP growth of 3% p.a. over the next couple of years.

Source: ANZ Bank

A major factor supporting the economy is an immigration boom, but the other side of the coin is an overheating housing market, and from a financial stability perspective this is becoming a headache for the Reserve Bank of New Zealand.

The economy is in good shape and doesn’t need another interest rate cut, but the current policy rate of 2.25% stands out like a beacon in the global market place and is attracting large flows from speculative and real money accounts (two thirds of the domestic government bond market is now offshore owned).

As a consequence, the exchange rate is rising, putting in jeopardy the Reserve Bank’s goal of achieving 2% inflation. Should the RBNZ cut rates again in an effort to topple the exchange rate at the risk of throwing more fuel onto the housing market fire ?

The situation is illustrated in this chart (click to enlarge). The exchange rate – as measured by the Trade Weighted Index (TWI) - has risen to 75.60.

Yet, all else being equal, if the inflation rate (currently not much above zero) is to get anywhere near target, the Reserve Bank’s forecasting model suggests the TWI needs to be tracking closer to 72.50.

If it doesn’t start heading down in that direction soon, it will have to drop inflation projections by about 0.5% when its updated forecasts are presented in the August 11 Monetary Policy Statement.

NZ Trade Weighted Index (TWI)

Source: Reserve Bank of New Zealand, Metastock

However, cutting the policy rate by 25 basis points to 2.00% at the August review comes with no guarantee the exchange rate will fall.

The Reserve Bank has cut five times in the last year (as indicated by the vertical lines on the chart) and the the response in the FX markets has been mixed.

Furthermore, as mentioned earlier, when it comes to the direction of NZDUSD, the US dollar side of the cross tends to be the primary determinant.

The best hope for a decline in the Kiwi dollar would be if it was to return to its status as a risk on/risk off barometer.

However, it’s had plenty of opportunity to do that lately and hasn’t obliged, at least not on risk off occasions, as indicated by its strength in the lead up to the Brexit vote.

Perhaps the situation is asymmetrical: NZDUSD will rise on risk-on events, such as a “stay” vote on Brexit, but not sell off to any extent on risk-off events such as a win by the “leave” camp.

If so, that’s a big problem for the Reserve Bank of New Zealand. Any further upside in the exchange rate from here will make things very uncomfortable for them.

No doubt then, when the Brexit results start to trickle in around mid-morning Friday local time, the RBNZ's FX dealers will have their fingers on the NZDUSD “sell” button in case any “disorderly” market conditions arise.

My technical analysis of NZDUSD (which I base all my own trading decisions upon) appears below.

NZDUSD  daily  chart  (click to expand)

 Source:  ThomsonReuters 

-- Edited by Adam Courtenay

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.

shenno shenno
Max you make some good points, however I can’t get my head around the suggestion that there is asymmetric risk around Brexit.
Like you mention, the world is long carry here - a symptom of the relatively benign volatility over the last few months. As you and I both know the carry trade prevails in periods of low volatility as can be seen with the VIX stuck in 12.5-17.5 from mid March to early June this year - and NZDs outperformance. I concede that the NZD held its ground remarkably well in the recent spike up to circa 23 in VIX - but there is a trigger point (I’d suggest somewhere in the 25-30 window) for VIX whereby the carry models will switch regime ( NZD’s low beta flips to high beta quickly & global movements trump domestic fundamentals) upon which there will likely be a rush for the exit door for those long NZD and NZD cross..
shenno shenno
In the event of Brexit it’s reasonable to assume that we see some sharp downside in equities and hence a spike in VIX well beyond this 25-30 trigger level - resulting in a nasty carry unwind in what will probably be an illiquid and disorderly market across FX in general - perhaps even more so after the last few days have seen the probability of Brexit paired back significantly...
Patto Patto
Good points Shenno, but I agree with Max: NZDUSD would seem to have little downside risk even if the UK votes "leave".


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