The moneymarkets continue to price future NZ interest rate levels well below what the RBNZ project in their latest monetary policy statement and well below what I believe will be actual interest rate outcomes based on the GDP growth and related inflation outlook. The current shape of the swaps yield curve has the market pricing of 90-day rates to be 3.50% in June 2012 and 4.25% in June 2013. It is a nice thought for home mortgage borrowers that interest rates will stay that low for that long, however with annual inflation at a 3.00% run rate during 2012/2013, the current price of term money looks far too cheap, and thus not sustainable.
There are several possible explanations as to why the interest rate markets continue to price term swap yields lower than what appears to be half reasonable:-
§ Repeating Christchurch earthquakes are pushing market interest rates down when they occur, however the economic data that has come out over recent weeks suggests that the negative impact on the wider economy from the earthquakes is actually less than what most thought.
§ Global investors are currently taking risk off the table with sharemarkets and commodity prices down. There has been some flight to quality into US Treasury Bonds as European debt issues and tightening of monetary policy in emerging markets makes investors re-think about risk and return. The buying of US bonds has forced their yields and our longer-dated swap rates lower. At some point, US bond supply, GDP growth and inflation risks in the US will force US 10-year Treasury bond yields back up from below 3.00%.
§ Earthquake reinsurance funds sitting around on deposit with the banks waiting for claims settlements is temporarily and artificially holding market interest rates lower than what they would normally be at.
§ Despite business and consumer confidence improving over recent months, most households with mortgages are staying at the cheaper floating rate for the meantime, thus no swap market paying demand on the banks from mortgage interest rate fixing. It might take the first OCR increase from Alan Bollard in December to change this thinking, by which time swap and fixed rate mortgage rates will be 0.50% higher than where they are now.
Bank economists who confidently forecast a 0.5% contraction in the economy in the March quarter a few months back are now hastily revising their forecasts to +0.3% for the quarter now that export/import, retail and manufacturing data has all confirmed the economy was travelling quite well through the earlier part of the year. Interest rate risks are extenuated right now due to the above factors causing market rates to be artificially and unsustainably low. It won’t last!
NEW ZEALAND DOLLAR MARKET COMMENTARY
Exporters need to hedge currency risks, not plead for subsidies
Various export industry and business lobby groups are yet again asking for “something to be done” about the high NZ dollar exchange rate value. There have been calls for direct RBNZ intervention in the FX markets, the Government to introduce controls on inward capital flows, a transactions tax on currency speculators and a return to a fixed exchange rate regime. What the protagonists are really asking for is someone (i.e. taxpayers and consumers) to subsidise their profits paid for by other sectors of the economy. These are selfish and ignorant demands by one section of the economy and it is reassuring to see the RBNZ and Government ignoring the pleas.
Should the NZD/USD rate stay above 0.8000 for a prolonged period this year it is likely to be negative for the economy in that exporter’s profits will be less than expected and thus business investment and jobs from the export led recovery lower than what they would have been under a lower currency value environment. However, any move away from the current free-floating exchange rate system would be disastrous for the New Zealand economy; we would lose the automatic stabiliser mechanism, the shock-absorber, when global commodity prices move sharply down.
To maintain NZD-based incomes our primary sectors need the NZD to depreciate when international commodity prices reduce. We saw a prime example of this stabiliser at work when commodities prices collapsed in early 2009 and the NZD/USD plummeted from 0.7500 to 0.5000. The spectacular rise of all commodity prices since this time has proven that the strong linkage goes both ways. It is a well recognised fact of life that the NZD at times can be the plaything of global currency speculators and moves around completely unrelated to our economic performance. However the speculative-induced volatility does provide market liquidity and is something that has to be dealt with as the alternative of not having a floating exchange rate is far more negative for the economy in the medium to long term. The result is that exporters who are financially exposed to an appreciating NZD/weak USD must either actively manage the risk under disciplined currency hedging policies or sell their product in another currency to other markets. The latter is often not possible, therefore pro-active hedging is required.
It is still surprising to read of the number of exporters who do not hedge and then make the biggest noise of complaint when the FX market moves against them. The NZD/USD currency risk is theirs to manage appropriately for their shareholders. Exporters who do operate disciplined hedging policies will not be currently converting USD export receipts above 0.8000, most would have weighted-average portfolio hedged rates below 0.7200 after the opportunities to sell USD’s forward at 0.6600 in May 2010 and at 0.7150 in March this year.
Commodity prices finally leading a Kiwi retreat?
The movements of the NZD/USD rate are just as much influenced by the fortunes of the USD on global FX markets as local developments. Over recent months, reinsurance inflows, international investors buying NZ Government bonds and reports of large Chinese funds earmarked for NZ have pushed the Kiwi dollar upwards on its own account. All the cross-rates have commensurately increased. Adding to those local positives was a more upbeat outlook on the NZ economy by the RBNZ on 9 June, bringing forward the timing of interest rate increases.
The fact that the NZD/USD rate has not attempted to re-test the 0.8300 highs since is testimony that the aforementioned local positives may have run their course and the USD has found some support in global FX markets.
One significant change over the last week is the pull-back in commodity prices. The oil price (WTI) has retreated from above $100 to $93/barrel since the Saudis walked away from OPEC production restrictions. Question marks over 2012 GDP growth in the US and globally have certainly reduced the speculative intensity to constantly drive commodity prices higher over recent weeks. The IMF has again lowered their 2012 global GDP growth forecast, this time from +2.8% to +2.5%. A stronger USD and weaker AUD are always the result of lower commodity prices.
The Kiwi dollar exchange rate to the USD has retreated from 0.8300 to 0.8000 and looks set to return to the support area of 0.7850 as the Greek/European debt mess goes from bad to worse and the Euro weakens as a result. A EUR/USD rate below $1.4000 (currently $1.4300) would pull the NZD/USD rate into the 0.7800’s.
The unanswered question for upcoming NZD direction is whether the FX markets have already fully priced-in the increase in NZ interest rates in late 2011/early 2012. The forecast appreciation of the Kiwi off its own bat at that time will not necessarily pan out as anticipated if all the related buying has occurred already.
It is really difficult to see the European central bank raising interest rates again in the near term when so many of their members (and the major European banks) are in such debt difficulties. The EUR/USD rate appears headed for $1.3500, which should see the Kiwi testing 0.7850 to the downside.