Roger Kerr posted on January 12, 2011 20:40
The local interest rate market commences a new year with very little change to outright rates and yield curve shape from the levels of late December.
The negative GDP number for the September 2010 quarter released just before Christmas was taken as further evidence by the doomsayers that the NZ economy was tanking and heading back to recession. The subsequent commentary from economists was that the RBNZ would not have to increase official interest rates at all in 2011. However, the marginally weaker economic performance in July, August and September last year was largely due to lower agriculture and manufacturing output for unrelated reasons.
I do not read too much into those weaker numbers and still contend that the super high export commodity prices will drive increased production, output and investment in the primary sectors this year. Likewise the low NZD/AUD exchange rate will drive increased manufactured/food exports to Australia, increase Australian investment in NZ manufacturing and also lift the already stronger Australian tourism arrivals into New Zealand. The domestic retail and construction industry sectors were not markedly weaker as the doomsayers had been predicting. It would be very unwise to extrapolate the flat GDP growth numbers experienced through the middle six months of 2010 and conclude that 2011 will be the same.
Apart from the current high NZD/USD exchange rate hurting exporters, all the stars are in alignment for stronger GDP growth in 2011. Add on the Canterbury earthquake rebuild and the Rugby World Cup positive influences and the stage is set for the doomsayers to be proved horribly wrong.
Activity levels in the domestic economy over the first half of 2011 will be determined by whether the extra income into rural pockets is utilised solely to repay debt (as the doomsayer economists and the RBNZ forecast) or whether some is spent on consumer and other items. I think the latter scenario is much more likely. Certainly the bargain prices for electronic gizmo’s (helped by a favourable 0.7600 NZD/USD exchange rate for importers) make it very attractive to upgrade and up-size! Retail sales look like they will be up marginally 1% to 2% on the previous year with the positive early December numbers fading towards Christmas due to poor weather and the lack of a weekend for shopping immediately ahead of Christmas day.
The NZIER quarterly survey of business confidence (QSBO) is due out this week and should display improved confidence levels. My view is that all the economic data releases over the first three months of 2011 will prove to be better than expected and gradually there will be a realisation that +3% growth does bring inflation risks later on and thus the current “super-loose” monetary policy settings with the OCR at 3.00% are just not appropriate for the economic outlook. As stated last year, by the time the RBNZ have the hard economic evidence they need to remove the monetary stimulus, it will already be too late and thus force them to lift official rates rapidly from March/April onwards. In addition to the RBNZ’s expected U-turn on the NZ economy, the improved global economy in 2011, led by the US and Asia, will also be aiding a stronger NZ economic growth outlook.
Net result of the economic changes will be a sharp increase in the one to three year swap interest rates from March onwards. The four to ten year swap rates will continue to be determined by US Government Treasury Bond yield changes, and those rates are only heading upwards.
Kiwi dollar spike upwards short-lived
It would pay not to read too much into the Kiwi jump up to 0.7800 between Christmas and New Year. In thin, illiquid holiday markets there was a squeeze on in NZD/AUD cross-rate trading as short Kiwi, long AUD position holders closed down their profitable positions before 31 December month-end and aggressively bought the Kiwi. The gains were short-lived and the Kiwi has since returned to the 0.7500/0.7600 area. The outlook for the NZD/USD rate over coming weeks and months is for further weakness to 0.7200 and perhaps lower. The main market driver for the lower Kiwi being the EUR/USD rate which is now below $1.2900 and headed for $1.2500. The Kiwi has some catching up to do on the EUR/USD rate and on top of that the EUR is still heading downwards. Stronger US economic data has come through in recent months as expected and the situation in Europe continues to deteriorate.
However, for the NZD/USD to trade lower it will not just require a lower EUR (which looks assured), but also a lower AUD against the USD. The AUD reached $1.0150 between Christmas and New Year, however has yet again recoiled from rates above $1.0000 to currently trade at 0.9940. Commodity prices and Aussie economic data will determine future AUD/USD movements and my gut feeling is that both these determinants will be weaker than what the markets expect over coming weeks. Whilst the mining/resources states of WA and Queensland were booming, floods in Queensland and perhaps marginally lower Chinese demand may take the edge off upcoming Australian economic data. Certainly the mortgage belts in Sydney and Melbourne are far from buoyant. Muted retail and housing data is what I expect out of Australia in the first part of 2011, thus interest rate increased being pegged back and the AUD losing ground against a stronger USD. The Japanese Yen exchange rate to the USD is also highly correlated to the AUD/USD rate and at some stage soon the Yen must jump to 90.00 from the current 83.00.
The Chinese tightened monetary policy further with an interest rate increase on Christmas Day. Timing that really gives two fingers to the financial/investment markets and the West! Volatile and illiquid markets provided some perverse outcomes over the Xmas/New Year period. The negative NZ GDP result should have sent the Kiwi dollar lower, it spiked up to 0.7800 instead. The Chinese monetary tightening should have been negative for hard commodity prices, they spiralled upwards but have since retreated on the stronger USD exchange rate.
Asian sovereign wealth funds have been active buyers of NZD denominated Government Bonds over recent months. The NZDMO is now issuing $300 million per week and tapping into Asian investors who are less likely to simultaneously hedge the NZD/USD exchange rate risk on their NZD investments. Thus they are net buyers of Kiwi in the FX markets. Many of these funds are diversifying their bond portfolios ways from holding European bonds for very good reasons. NZ is a beneficiary of this investment asset rebalancing out of Europe; however their NZD buying makes it harder for the Kiwi exchange rate to fall and help our export-led economic recovery.
The chart below plots the NZD/USD rate against the EUR/USD and demonstrates the widening of the correlation gap over recent months. Very difficult to see the EUR moving up, therefore the NZD has to move down to 0.7000 at least to restore the correlation equilibrium.