New Zealand Dollar Rises as Market Tensions Ease but RBNZ Offers Little Support in Latest Stability Report

- NZD rises as global market jitters fade and US Dollar eases.

- But RBNZ underlines domestic headwinds again on Wednesday.

- Some strategists suggest worst is now over and warm to the Kiwi.

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The New Zealand Dollar rose broadly Wednesday as market jitters over European politics eased allowing 'risk-on' currencies such as NZD to catch a bid.

With risk sentiment in the driving seat, the NZD/USD rate was quoted 0.96% higher at 0.6954 during the morning session Wednesday while the Pound-to-New-Zealand-Dollar rate was 0.81% lower at 1.9084. The Kiwi also recorded gains over all other developed world currencies barring the Swedish Krona.

While the NZD could count on global drivers for support, domestic developments suggest there might be constraints to any run higher in the currency.

Foreign exchange traders eyed the latest Reserve Bank of New Zealand (RBNZ) financial stability report released overnight which offered hints at why the Kiwi might remain a laggard for a while to come.

May's financial stability report did nothing to persuade markets the RBNZ is any closer to an interest rate rise than it was when new governor Adrian Orr led his inaugural monetary policy press conference, suggesting the Kiwi will remain vulnerable to other currencies whose central banks are raising interest rates. 

The RBNZ noted in its May report that while household debt is no longer rising at the pace it once was, debt-laden households are a prime source of concern over Kiwi financial stability.

They will be the most sensitive to higher interest rates so will be a key consideration ahead of future monetary policy changes. 

Domestic banks and their reliance on foreign funding also came in for scrutiny, which is a salient topic in light of recent market turbulence in Italy and Europe.

Policymakers noted that banks have reduced their reliance on foreign funding by growing customer deposits and borrowing over longer horizons but, nonetheless, flagged that global market instabilit could force Kiwi borrowing costs higher. This would be tantamount to an RBNZ interest rate rise, just without the associated lift to the currency.

"There are no fresh implications for the Official Cash Rate or the housing market from the May Financial Stability Report and we expect gradual increases in the OCR from August 2019," says Elias Haddad, a senior currency strategist at Commonwealth Bank of Australia.

The Reserve Bank of New Zealand has held its cash rate at record low of 1.75% for more than 18 months now, citing below target inflation and risks to the economic outlook. More recently strategists have increasingly abandoned forecasts for a 2018 interest rate rise this year and, egged on by the RBNZ, most now say it will be at least the second half of 2019 before the RBNZ raises rates. 

"Emerging capacity constraints are projected to see New Zealand’s consumer price inflation gradually rise to our 2 percent annual target. To best ensure this outcome, we expect to keep the OCR at this expansionary level for a considerable period of time," Adrian Orr told members of the press earlier in May. "This is the best contribution we can make, at this moment, to maximising sustainable employment and maintaining low and stable inflation."

After all Kiwi inflation remains stubbornly below the midpoint of the RBNZ's 1% to 3% target and has done so ever since the final months of 2012. Inflation must first show signs of making a sustainable return into the upper quartile of the target ban before an interest rate rise will become likely. 

Currency markes care about the RBNZ because interest rates are the raison d'être for most moves in exchange rates. Changes in interest rates, or hints of them being in the cards, impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Adrian Orr’s first policy statement on 10 May provided the spark for AUD/NZD to break its ranges to the top side. By declaring that the “direction of our next move is equally balanced, up or down”, the RBNZ provided a clear contrast to the RBA messaging. This should persist at least for the next few months, helping AUD/NZD maintain notably higher ranges," says Sean Callow, head of G10 FX strategy at Westpac. 

New Zealand's Dollar had seen a strong start to the year when it rose by more than 5% over the US Dollar during the eight weeks to the end of February however, this increasingly downbeat outlook for monetary policy has driven the Kiwi down by 7% against the Dollar since late April, making for an almost bottom-of-the-league performance.  

Headwinds for the Kiwi have been made worse by rising US interest rates that have forced American bond yields higher and shocked the US Dollar back into life. New Zealand's 10 year Treasury yield has fallen precipitously in 2018 while the US 10 year Treasury yield has risen to multi-year highs above the 3.1% level.

This means that investors are incentivised to sell Kiwi Dollars and to buy the greenback in order to invest in the American bond market rather than vice versa. This is the opposite of how the so called carry trade, which has traditionally propped up the Kiwi relative to its international peers, used to work. 

Nonetheless, a still-small minority of strategists have recently begun to suggest the worst period of performance is now behind the New Zealand Dollar.

"We have been warming up to the NZD. The currency is one of the cheapest in the G10 (next to EUR and CHF), as it materially lags developments in the terms of trade," says Mazen Issa, a senior FX strategist at TD Securities. "We think risk/ reward is building for kiwi outperformance on the dollar bloc crosses and expect relative wage pressures to anchor AUDNZD lower."

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