The economic data should confirm the higher one to three year swap rates; however perhaps the more dominant influences on these swap interest rate from here will the NZD/USD exchange rate and US bond yields. I remain confident that the NZD/USD exchange rate will retreat from 0.7700 back to 0.7000 due to a recovering USD (which already seems to be occurring) and this will negate any need to maintain NZ short-term rates lower for longer due to a higher currency.

 

Governor Bollard’s “jawboning” down of the NZ dollar last week was not too surprising and one would agree with his scenario of lower interest rates for longer if the NZD remained up at 0.8000, as weaker export performance would reduce GDP growth. I do not anticipate that this scenario will play out due to the FX market view that China is tightening monetary policy (bad news for hard commodity prices and the AUD) and the US dollar was sold before QE2 and is now gaining ground on unwinding of market positions. A lower NZD/USD exchange rate and continually improving economic data still suggests that by January or February the RBNZ will be forced to review their 2011 GDP growth forecasts upwards.

 

Longer term, I still hold to the view that NZ interest rates will settle at around 5% to 6%, lower than historical averages. A major determinant of the lower and more stable interest rate environment is the introduction of the Core Funding Ratio regulatory rules by the RBNZ on the banks’ debt funding books. We have already witnessed the impact on retail deposit interest rates from the banks needing to fund their books from a higher proportion of domestic money. The banks have been paying 4.50% to 5.00% for medium term funds for over 12 months now. In a way this has caused monetary policy settings to be not as super loose at a 3.00% OCR suggests. The true market interest rates have been well above official rates for a long time, therefore the bank’s cost of funds have been higher. Therefore, the Core Funding Ratio has already made an impact on general monetary conditions without any OCR change from the RBNZ.

 

As I have stated previously, it is not a healthy situation for monetary policy management to have actual market interest rates (bank deposit rates above 4.00%) so far away from the Official Cash Rate. Mr Bollard might be raising the OCR next year (only catching up to market rates) and it will have no impact on the banks’ cost of funds or spending/borrowing/saving behaviour in the economy

 

What is now becoming apparent now is that a number of the banks are becoming very flush with excess cash on their balance sheets as they are not seeing any lending growth. Big corporates borrowing billions from the US Private Placement debt market will exacerbate this situation. The banks are being forced to revise down lending margins and they are no longer paying up for retail deposits now that their funding books are in order to meet the Core Funding Ratios.

 

 

 

The QE2 and the G20 have come and gone, the markets are correctly re-focussing back on Europe’s sovereign debt problems and China is tightening monetary policy. All these developments over the last week do suggest that the Kiwi’s spike from 0.7500 to 0.7990 will be short-lived and reversed as rapidly as it happened. Already a stronger USD and weaker AUD have pulled the NZD back to 0.7730.

 

Global equity and commodity markets ran hard upwards ahead of the QE2 announcement, but now the global market environment and sentiment has changed abruptly over the past 10 days. The most significant development is the tightening of monetary policy in China. They are worried about their general inflation and a few hotspots of property market bubbles. Growing tenant vacancy rates for buildings in Beijing and Shanghai tells me that they have over-supplied the market and thus raw material demand (steel) will pull-back from the red hot rates of recent times. The Chinese commodity importers will also be reluctant to pay the current high prices and will rely back on their inventory stockpiles. Add on to this equation the fact that the commercial lending banks in China have already reached their quota of loans made for the year and it sums to a higher cost of credit and a lower availability of credit in China. The AUD/USD rate has already reversed from $1.0150 to 0.9870 on these Chinese developments and more AUD weakness could be in store.

 

The latest US, Chinese and European economic news is stimulating unwinding/profit-taking across the board in equity, commodity and currency markets after the gains over recent months.  In addition, the time of year in the run-down to Xmas holiday periods also means a greater motivation for traders and hedge funds to square their speculative positions and take their profits. I expect to see weaker investment and commodity markets over the next six weeks to Xmas as long positions are unwound. 

 

It was anticipated that the focus would come back on Europe once the QE2 was known. The European sovereign debt situation has deteriorated further and the currency markets are selling the Euro as Greek and Irish Government Bond credit spreads blow out yet again. My view is that the European Central Bank (“ECB”) will be forced to cut their 1.00% official interest rates at some time over the next few months. They need to stimulate consumer spending with lower interest rates to get their economies to recover to counter the tight fiscal austerity policies being adopted. A cut by the ECB would surprise the markets and cause significant Euro weakness against the USD; back to $1.2500 is my estimation. That 9% depreciation of the Euro against the USD would pull the NZD/USD rate from the current 0.7750 to 0.7000.