The change in wording and tone in the RBNZ OCR review statement last week to a more positive outlook for the economy this year (compared to the outright dovish tone in the December MPS) indicated to me that the central bank has finally recognised it needs to rectify the jam they have created for themselves.
By leaving official interest rates 2.00% below true market interest rates over the last 18 months, the RBNZ have painted themselves into a corner in terms of monetary policy flexibility and effectiveness. They now run the real risk of having to catch-up rapidly in the second half of 2011, increasing official rates in big steps from 3.00% to 5.00% to just catch-up to current market rates. All this will do is potentially pushing the exchange rate up. Domestic economic activity in terms of the behavioural decisions of investors, borrowers and consumers will not change as market interest rates will not change too much (they are already at 5.00% i.e. the banks’ cost of funds).
The more upbeat outlook from Governor Alan Bollard and his economic gurus is correct in my view. The RBNZ realise that they now have to condition the moneymarkets and public expectations that the emergency low rates are no longer appropriate and increases in official rates are coming. The strategy is to get some increases in the two and three year market swap rates ahead of time so that they can point to higher market levels when they increase official interest rates later on. Off course they have left this action far too late, allowing the OCR to be 2.00% below the actual market price of money for so long was always going to cause them a problem at some point. That time has now arrived and they will need some smart manoeuvring to get themselves out of this predicament.
Leaving OCR increases until too late in the piece in September will cause too much collateral damage to the export sector (an economy) with the NZD being pushed up on its own.
Our economic growth forecasts for the first and second quarter of 2011 is for quarterly increases greater than 1.00% each, when the data is announced in June and September. A rebound in agricultural and manufacturing production after the weather related reductions in the second half of 2010, coupled with improving retail/housing sectors will be behind the higher GDP growth numbers.
The RBNZ need to pre-empt these stronger figures, thus the change in tone in last week’s OCR statement which surprised the naysayers/doomsayers on the performance of the economy (typically Wellington-based economic forecasting groups). It appears the RBNZ finally understand what the record high export commodity prices do to growth in the NZ economy.
What all this means for the direction of interest rates and the slope of the yield curve this year is that the three to 10 year swap rates will be moving progressively higher over coming months as the markets price-in the RBNZ changes and the US bond yields continue to increase. Those borrowers not fixed to high percentages should concentrate new fixings in the two to four year part of the interest rate yield curve. Fixed interest investors can still expect higher market base rates later, however the corporate credit spreads (margins) will be lower as the shortage of new-issue bonds cause demand to exceed supply.
NEW ZEALAND DOLLAR MARKET COMMENTARY
Calls of NZD intervention miss-placed and miss-guided
The value of the NZ dollar has been under the spotlight from many groups over recent weeks; with several parties calling for intervention to bring the value down. That is unlikely to happen as the pre-conditions for the Reserve Bank of New Zealand to intervene directly in the FX markets by selling NZD’s are not fulfilled. The FX market is not dysfunctional and the overall TWI value of the NZ dollar is not at an extreme over-valuation level that would have major negative economic consequences. The NZD/USD exchange rate is above 0.75 again because the EUR has recovered from $1.30 to $1.36 against the USD and global commodity prices have re-stimulated new buying interest in the commodity currencies, the AUD and NZD.
The parties calling for currency intervention include the Green and Labour political parties, who are misguided in their belief that the Government or RBNZ can take on, and beat, global FX investors and speculators in volatile currency markets. One reason the RBNZ does not intervene is that they would be crucified in the markets by much larger punters and would loose taxpayer’s money. Another group calling for intervention to bring the NZD down are the sawn timber exporters who have had to close and downsize their sawmills and lay-off workers. If these sawmills are only exporting into the US market in USD’s they have been hit by a double whammy of adverse currency conversion and a major slump in the US house building market. In a strict commercial sense it is clear that these sawmill/export companies are not operating prudent foreign exchange hedging policies.
It was only eight months ago in May 2010 that the NZD dipped to 0.6600 when the Euro was sold heavily on the Greek sovereign debt crisis. Many USD exporters in other industries transacted 12-month hedging at those currency levels when they had the opportunity. That hedging at rates below 0.7000 is however rapidly running out now, so it will be critical for many exporting companies and industries as to what the NZD/USD rate does over coming months. Further NZD gains to above 0.8000 will choke-off expected 3% GDP growth this year. Even if the NZD/USD rate remains above 0.7500, profitability and jobs in exporting industries will still be under threat. Thankfully for the agriculture sector the high USD export commodity prices are off-setting the high currency value in terms of NZD farm-gate incomes.
Direct currency market intervention will not be forthcoming anytime soon to alleviate these financial pressures for some. Those exposed to a high NZD/USD value will be praying that the USD itself makes gains in global FX markets, as local NZ economic and policy situations are not causing any currency weakness from the NZD side of the currency pair. The prospects for the USD on the international stage are (thankfully for the export sector) looking more favourable:-
· US economic data has certainly picked-up over the last 4-5 months
· US market term interest rates (three years plus) have started to increase, anticipating US official interest rates needing to lift in 2012.
· Civil unrest in the Middle East against dictatorial Governments may spread wider (into Asia?) and cause an investor flight to quality to the US dollar.
· The gains of the Euro to $1.3600 do not look sustainable in the light of continuing sovereign debt problems in Euroland.
The RBNZ did not help the exporters last week with an accurate musing in the OCR review that the NZ economy has improved over recent months. The NZD/USD rate moved up another cent to above 0.7700 as a result of the RBNZ statement. The RBNZ cannot assist the export sector at this time by reducing official interest rates to surprise overseas investors and cause NZD selling. Official interest rates have been allowed to stay too low at the 3.00% emergency stimulus levels put in place in March 2009. By allowing official rates to remain 2.00% below market interest rates at 5.00% for two years, the RBNZ now find themselves in a jam of their own creation. When they have the firm evidence of growth in the second half of 2011 they will increase official rates quickly in large steps to catch up to the true market interest rates already at 5.00%. That could well cause further NZD buying in the FX markets and hurt the export/productive sector even more. At a time when a cut in official interest rates would lower the NZ dollar, the RBNZ have painted themselves into a corner of having to increase official rates. The RBNZ’s mandate is to manage monetary policy without causing undue volatility in the exchange rate that hurts GDP growth.
It is not an easy situation for the NZ Government either. The fiscal deficits and the requirement to borrow the shortfall means that they need to attract Middle Eastern and Asian sovereign wealth funds to buy our Government bonds. The overseas investment is flowing in, however unfortunately many of these new investors into our Government bonds are not hedging the FX risk after they make the investment. The net result is outright buying of NZD’s in the FX markets for the initial capital inflow, forcing the NZD/USD rate higher. A correction downwards in global equity markets over coming weeks/months should mean investor risk is taken off the table and the NZD/USD heads south as a result.
Exporters will be praying for intervention of the divine type that the USD itself appreciates against the Euro and the downgraded credit rating of the Japanese Yen.