Reserve Bank of New Zealand to call the shots on kiwi dollar this week
- Traders are awaiting the RBNZ Monetary Policy Statement due out on Thursday
- The NZ dollar has moved much higher than forecast
- Monetary conditions not be as tight as record low interest suggests
Along with its Australian counterpart, NZDUSD has been a significant winner from the slumping US dollar. But the Kiwi finds the air a bit thin above 0.75 and will struggle to make any further progress from here. It won’t get any assistance from the Reserve Bank of New Zealand’s Monetary Policy Statement either, which is due out on Thursday. The central bank sees the rally in the exchange rate as an unwelcome hindrance along an already unsteady pathway to 2% inflation.
The statement will contain updated economic forecasts, including a useful alternative scenario analysis. Assumptions around the exchange rate are a key input into the forecasting model and, unlike most central banks, the RBNZ doesn’t just assume the rate applying at the forecast date will hold for the next couple of years. Rather, they have a crack at projecting the path the exchange rate will take.
Any deviation from the above path would have upside or downside implications for the baseline forecasts around economic activity and the rate of inflation. That would bring the alternative scenario analysis into play.
The projected path for the exchange rate in the last set of forecasts, published in May, is shown in the chart below (click to enlarge). Clearly the actual path has deviated from the projected to a significant extent. All else being equal, that will mean GDP and inflation forecasts will need to be lowered this time around, as will the path for the policy rate. At the moment it sits at 1.75% and the May forecasts had it staying there through until late 2019.
Trade weighted index chart
Source: Reserve Bank of New Zealand, Metastock
A case can be made that the strength of the currency is justified by the record high in New Zealand’s terms of trade, as demonstrated in the chart shown below.
That is adding to national income and helping to support consumption levels at a time when subdued wage growth is pulling in the other direction. In times past that would have been a valid argument, but in the days of inflation targeting – and New Zealand was a pioneer in that regard – central banks look to the currency as a support tool for its policy.
New Zealand Terms of trade chart
Source: Bank of New Zealand
In the May statement the RBNZ had inflation drifting lower in the period ahead, bottoming out at 1.1% next March and then gradually rising to just above the 2% target by late 2019 (hence the upward move in the policy rate then).
But in the meantime we have seen the second quarter inflation numbers come in lower than expected, the exchange rate rise, residential building activity slow and labour market conditions remaining subdued.
Taking it all into account, analysts at the Bank of New Zealand (not to be confused with the Reserve Bank) think that there is a good case for the RBNZ to lower its inflation forecast significantly this week, as shown in the chart below. Inflation would drop well under the 1%-3% target band and not reach the target mid-point until 2020.
The markets would be caught flat-footed if the RBNZ did issue such a downbeat inflation forecast, because that would imply there was a good case for a rate cut. The bank went on in the May statement as saying that there is an equal chance of a cut or hike: it all depends on the data, and the data since has generally been weaker than they expected.
But private sector analysts have given little credence to the idea monetary conditions would be eased again. We see this in the Overnight Index Swap curve: a 25 basis point increase in the policy rate to 2% by August 2018, as shown in the chart below, but even then it is still a year ahead of RBNZ guidance.
Traders should be aware that the RBNZ’s forecasting record has been superior to that of private sector over the last year or so.
New Zealand Overnight index swap chart
Source: National Australia Bank
It’s also worth noting that monetary conditions are not as accommodative as a record low 1.75% policy rate would suggest. Trading bank deposit and lending rates are much higher, reflecting the RBNZ’s insistence they fund more of their activities off the local market, rather than more fickle offshore sources.
Also, the RBNZ has estimated the the neutral policy rate is about 3.5%, down significantly from previous levels. This suggests conditions have not been as accommodative as previously thought.
Source: Reserve Bank of New Zealand. Create your own charts with SaxoTrader; click here to learn more.
The RBNZ’s updated forecasts and their commentary around them will be a big test for NZDUSD later this week. A lower inflation track and forward guidance that a rate cut is just as likely as a rate hike in the months ahead could knock the Kiwi off its perch, especially if the US dollar is coming up for air the time.
Another test will come as we get closer to the general election to be held on September 23. The ratings agencies have given the ruling National Party good marks for its management of the economy, but it has been in government for nine years and a combination of minor parties may be able to form a coalition and take power, something the rating agencies are likely to view with suspicion. Labour, the main opposition party, has be languishing in the mid-20s in polls but last week belatedly changed leaders, installing a charismatic 37-year old named Jacinda Ardern.
So now it’s game on. Updated opinion polls are keenly awaited by political junkies – and NZDUSD traders.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.