Whist our short-term interest rates are determined by RBNZ monetary policy settings based on the inflation/growth outlook, our long-term interest rates (swaps rates beyond three years) are largely driven by global bond markets i.e. swap interest rates track NZ bond yields, which follow US and Australian bond yield direction. In many ways our longer term interest rates behave like exchange rates in that they are relative prices. If global bond investors prefer one country’s government bonds over another they will buy the preferred bonds (driving the yield down and bond price upwards) and sell the less preferred bond (yield up, bond price down). So, NZ bond and swap interest rates will move relative to the market movements over other bond markets. Over the past six months, fixed interest fund managers and sovereign wealth funds have been divesting European government and corporate bonds as they continue to go down in value and have been seeking alternative government bonds to invest into. New Zealand Australian bond markets have benefitted from this relativity change, perhaps artificially holding our long-term interest rates lower than where they would otherwise be given the increased Government bond issuance and inflation/growth outlooks. The question is will global investors continue to buy our bonds when they have finished with their selling of European bonds? I suspect so, however the latest credit rating downgrade news out of Europe does not suggest this is going to happen anytime soon!

The equally important driver of long-term interest rate direction is local investor demand and borrower supply of debt/bonds onto the market. Local fixed interest fund managers (who were not short of portfolio benchmark duration) produced some pretty impressive returns last year as markets yields declined. My expectation this year is that these fixed interest managers will now position their portfolio risk from the short-side of benchmark duration i.e. shorten their duration by being sellers of longer-dated securities, not buyers. They will also be wary of the European financial problems increasing credit spreads across the board, another reason not to be a buyer of long-dated securities. On the other side of the market, we can expect to see the NZ Government and corporate borrowers issuing as long as they can. All this adds up to higher market swap yields from here rather than a continuation of 2011 decreases.

Short-term interest rates over coming months will oscillate on the prospects of NZ achieving 3% GDP growth in 2012 or not. My continued view is that the European recession/crisis does not drag the US and Asian economies down and thus our economy has great conditions for strong growth with high export commodity prices and low interest rates. Since the last week of December the moneymarkets have removed the pricing-in of cuts to the OCR in 2012. Current pricing is for no change at all in 2012. However, as the year unfolds I expect a stronger than expected economic data to progressively change that benign outlook.

NEW ZEALAND DOLLAR MARKET COMMENTARY

2012 track for the Kiwi dollar? Sideways then up!

The Kiwi dollar’s out-performance of the Euro against the USD over the past month is hardly surprising, given the relative economic performances and outlooks for the respective New Zealand and European economies. However, the speed of the rise in the NZD/EUR cross-rate over the past few weeks has probably more to do with stronger Chinese economic data, thus a stronger AUD (to above $1.0300) than Europe/NZ differences. The NZD/USD rate continues to track the AUD/USD exchange rate and has for the meantime de-linked from the EUR/USD exchange rate.

In the short-term, the NZD gains to above 0.7900 may be short-lived and given back due to weaker NZ and Australian economic indicators this week. The NZIER Quarterly Survey of Business Confidence may well be weaker again as respondents over-estimate the negative impact of Europe on the NZ economy. December quarter’s CPI inflation number due out on Thursday may also be lower than consensus forecasts of a +0.40% quarterly increase. If Australian employment figures (Thursday) and Chinese GDP numbers (today) also come in below forecast, both the Kiwi and Aussie will be sold lower. Overall, I see the Kiwi dollar trading in the 0.7500 to 0.7950 band over coming months, thus not breaking above the 200-day moving average line just above 0.8000 until later in the year.

Longer term, exporters/importers and others with currency exposures should be watching the following lead-indicators for the Kiwi dollar to build the probability and risk weightings of future movements:-

§  The copper price as a surrogate/proxy for Chinese economic growth/demand, in turn dictating the fortunes of the AUD/USD exchange rate (which we follow).

§  Global share indices and the VIX Volatility Index: investor risk sentiment is still critical for the Kiwi as investors do not have many stable currencies to choose from these days.

§  NZ economic data and more importantly residential property market trends: Remember that the mandarins at the RBNZ still hold a general paranoia about rising house prices forcing up inflation risks. Their past concerns about this have been wrong, however that seems to not have changed their predisposition! Later in the year New Zealand will be the only country adjusting monetary policy settings from “loose” to “neutral”.

§  US Institute of Supply Management (“ISM”) and Chinese Performance of Manufacturing (“PMI”) Indices: I anticipate both moving higher over coming months year as the world realises that the European problems are not that negative on the rest of the world. Rising manufacturing indices point to an appreciating NZ dollar.

In summary, sideways for a few months and then the risk probability certainly increases for the Kiwi dollar to be trading above 0.8000 again during the second half of 2012.

“Big Mac” Currency Index does not rate NZD as over-valued

The “Burgernomic” exchange rate currency index published annually by The Economist magazine has to be taken with a grain of salt as it does not take account of the different wages and rental rates between the countries. However, over the years it has been fairly reliable in predicting which currencies are overvalued of undervalued in the extreme. According to this year’s Index the Kiwi dollar is marginally undervalued by 5%. Unsurprisingly, those currencies with extreme undervalued currencies are not free-floating exchange rates (India and Chine) and those over-valued are either safe-havens from the global turmoil (Swiss Franc) or have delivered economic out-performance (Brazil and Australia)