Roger Kerr posted on April 25, 2011 19:06
The OCR review this Thursday by the RBNZ will not shed much light on the likely timing of interest rate increases from the current “super loose” monetary policy settings.The RBNZ will highlight the booming export prices, how rural NZ is still repaying debt to the banks and not yet spending and the economy being disrupted this year by the earthquake.
Whilst the RBNZ may be comfortable with current core inflationary pressures being “subdued” (outside food and energy), they will be very uncomfortable about forecasting the annual inflation rate being closer to 3.00% than 2.00% in 2012. Such an inflation forecast would normally force them to be tightening monetary policy today; however they cannot do that for obvious reasons, therefore their inflation forecast will not be near to 3.00%.
As discussed in this column last week, there are many compelling reasons why future inflation in NZ is going to be well above current complacent forecasts. I heard a bank economist on the radio this morning (the non-commercial station that runs on taxpayer’s generosity, not commercial ratings!) say that current and future inflation was “subdued”. What planet do they live on? Obviously they do not get out much. My reading of price-setting behaviour by business firms over the next 12 months is that they will be seeking to recoup current compressed profit margins (due to increased input costs) with selling price increases as end demand lifts over the next 12 months. Add in higher wage claims after several years of zero increases for many workers and you have an environment of supply-side price pressures that the RBNZ and complacent bank economists cannot ignore.
How local investors and borrowers see the short-term interest rates moving in the future in response to inflation and thus monetary policy responses is in many respects captured in the three-year swap interest rate. Since the rebound up to 5.30% in late 2009, the three-year swap rates has broadly remained below a downtrend line . A move back above 4.00% would break above that downtrend line, and this appears far more likely than staying below it going forward. Given the 2012 inflation forecast of 3.00% it is very difficult to see the three-year swap rate being too much below 5.00% in 12 month’s time.
NEW ZEALAND DOLLAR MARKET COMMENTARY
The USD, commodities and credit-rating hold the key for Kiwi dollar movements
The NZ dollar exchange rate against the USD is back above 0.8000 again as the USD continues to weaken on global foreign exchange markets. On all the previous occasions the Kiwi dollar has traded above 0.8000 it has been unable to hold on to the lofty levels and has for various reasons reversed rather quickly back down again. Will this occasion be any different?
For the NZD/USD rate to reverse out of its strong uptrend since 0.7150 in 17 March, two things have to change in global financial/commodity markets:-
1. The USD currency value needs to strengthen in international FX markets, particularly against the Euro which has made gains due to the recent European interest rate increases. US economic data has been quite robust over recent months, particularly in the manufacturing/employment part of the economy. However, the crucial residential property and thus household sectors are still struggling. The US Federal Reserve meets this week and the majority vote within the Fed stall favours a continuation of super loose monetary conditions. Whilst they are still printing dollars the USD currency value will remain under downward pressure. The mood within the Fed needs to shift to a position that the US economic recovery is running on its own stream and then the FX markets will start to price-in a greater probability of increasing US short-term interest rates. When this happens the USD should start to recover against the EUR. The NZD/USD rate does follow the EUR/USD exchange rate and a return of the EUR/USD rate to $1.3000 from $1.4500 over coming months should see the Kiwi back down 10% as well to the low 0.7000’s. It will require more negative sovereign debt news out of Europe and a shift in current Fed thinking to cause the USD to strengthen in this way.
2. Global commodity prices have continued to make gains as strong Asian buying demand meets restricted supplies in many commodity groups. In many respects, the 30% increase in New Zealand’s agricultural commodity prices over the last 12 months justifies the much stronger NZD currency value; however the commodity prices need to keep rising for the currency gains to continue. The growth/commodity currencies, the AUD, CAD and NZ, are always bought up by currency traders and speculators when hard and soft commodity prices increase in global markets. It was expected that the current tightening of monetary conditions in China (designed to slow growth/demand and restrict inflationary pressures) would reverse the uptrend in global commodity prices. To date this has not happened. It seems that it might take actual increases in US short-term interest rates to take the gloss of rising commodity prices. US interest rates are unlikely to increases until early 2012; however FX and commodity markets are always looking forward and factoring in future economic and financial/investment market conditions.
Off course the two aforementioned global forces are inter-related in that the USD always weakens against major currencies when commodity prices increase (and vice-versa) All commodities are traded in USD’s and the USD exchange rate adjusts to keep stable buying and selling prices in major currency terms.
On the domestic front, the continuing ”front-running” bond issuance strategy by the NZ Government to borrow larger amounts early whilst the investor demand is strong is adding to the NZ dollar buying pressure. Asian investors are dominating the buying of NZ Government bonds over recent months and they do not tend to hedge the currency risk on their investment. The net result is buying of NZD’s to buy the NZD denominated bonds. These investors and the forex markets themselves have not yet started to build in the risk of a NZ sovereign credit rating downgrade by Standard & Poor’s. The probability of a downgrade has arguably increased from a 30% chance when we were placed on “negative outlook” a couple of months back, to nearer 50% chance today as the Christchurch earthquake reduces tax revenue income into the Government and increases Government spending/debt. The Government’s budget on 18 May will need to satisfy Standard & Poor’s that economic policy initiatives contained therein will reduce future Government spending and thus budget deficits. Finance Minister Bill English has very little wiggle room in his budget to keep both Standard & Poor’s and the voting public happy. A credit rating downgrade would certainly reduce overseas demand of NZ Government bonds, thus the current font-running bond issuance exercise is smart (and prudent) risk management by the NZ Debt Management Office. If overseas buying demand for our bonds reduces after a credit rating change, the Kiwi dollar looses a major support.