Inflation at the heart of Aussie and Kiwi directions
- Quarterly CPI updates will determine monetary policy moves
- Commodity prices are up but offset by higher exchange rates
- Cross currency basis makes Australasian bonds unattractive
By Max McKegg
AUDUSD and NZDUSD are on the back foot today after the USD regained some upward momentum. Local economic events also played a part: The Reserve Bank of Australia issued a non-committal interim monetary statement and prices fell at the latest global dairy trade auction.
Important inflation updates are due in New Zealand (October 18) and Australia (October 26) ahead of quarterly monetary policy statements early next month.
Money market pricing suggests a high probability of a rate cut from the Reserve Bank of New Zealand (November 10) and a moderate probability of a cut from the Reserve Bank of Australia on Melbourne Cup day (November 1).
In yesterday’s interim statement, the new RBA governor Philip Lowe suggested inflation is not a concern at the moment, despite being well below the 2%-3% target band
“Inflation remains quite low. Given very subdued growth in labour costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time,” Lowe said.
That might change if the September quarter number surprises on the downside, as it did in June.
All about inflation: There will be CPI updates in both Australia and NZ this month. Photo: iStock
Lowe has indicated he wants to give more weight to “financial stability” issues (read the housing market) in setting monetary policy, but by leaving the inflation target where it is – when he had an opportunity to lower it - he has created a rod for his own back.
Ahead of the CPI releases and policy statements, the AUD and NZD will take their direction from the US dollar and commodity price movements.
A major reason for the resilience of AUDUSD in recent months has been the price action in commodity prices.
Even though iron ore came back a bit last month, this was more than offset by a rise in coking coal, leaving the rally in the RBA’s commodity price index intact (see chart below).
However, given the extent of the drop since the peak in 2012, the rally has been modest. And with AUDUSD also moving up lately, the index is actually down 5% in AUD terms over the last 12 months.
That’s why the RBA’s statement yesterday repeated previous warnings that an appreciating exchange rate could “complicate” the Australian economy’s transition from being mining-investment driven to broader based activity.
NZDUSD has also been gaining support from commodity prices as shown in this chart, lead by a 30% increase in dairy prices.
However, as with Australia, much of the economic gain has been eaten away by a matching rise in the exchange rate. In NZD terms an index of commodity prices is 5% lower than it was a year ago as illustrated by this chart.
Commodity prices are only one side of the coin for the Aussie and Kiwi. Even though the forward rate curve prices in an 80% chance the RBNZ will cut the official cash rate to 1.75% at its next policy review on November 10, and the RBA will cut to 1.25% mid next year, the curves still stand out in a G10 context (see chart below).
Both central banks want their exchange rates to decline but it won’t happen until the yield gap closes. The best hope of that happening is via the USD with a 60% probability now priced into the US curve that the Fed will hike the federal funds rate in December.
Yesterday’s price action in the dollar suggests the market is warming to the prospect and it wouldn’t take much for it to build a head of steam.
The ISM services report later today could be a trigger as could Friday’s employment report, especially if the unemployment rate edges down after a few months of stagnation due to a rising participation rate.
Source: Bank of New Zealand
Real money investors have been more attracted to the longer end of the Australasian yield curves where rates well in excess of 2% have been on offer for AAA rated government bonds (AA in New Zealand’s case).
However, that window of opportunity has been closing as spreads over the G3 bond markets narrow.
In fact, Japanese and European investors who prefer to hedge the currency risk have been virtually locked out of the Australasian market over the last couple of months as the cross-currency swap basis widens. The cost of the hedge now exceeds the yield.
More background on this issue can be found here
Source: Morgan Stanley
My chart analysis of NZDUSD appears below. For more information, see today's trade view: Further downside potential ahead for NZDUSD.
NZDUSD daily chart (click to expand)
-- 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.