The New Zealand Dollar Advances after Second-quarter Data Shows Inflation Pressures Beginning to Build

-NZD rises after data shows inflation pressures building.

-Kiwi inflation hits 1.5%, expected to rise further in 2018.

-Data could see market reassess RBNZ interest rate outlook.

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The New Zealand Dollar rose broadly Tuesday after official data showed consumer price pressures beginning to build in New Zealand, which may now prompt traders to reconsider their expectations around when the Reserve Bank of New Zealand (RBNS) is likely to begin lifting its interest rate up from record low levels. 

New Zealand inflation rose by 0.4% during the second quarter, which was down from 0.5% during the first three months of the year and beneath the consensus for another 0.5% quarterly rise. However, this pushed the annual consumer price index up to 1.5%, which is in line with the latest forecasts from the RBNZ. 

Housing and household utility prices made the greatest contribution to the quarterly increase in inflation while recreational goods and services formed a drag on inflation, with prices falling -1.4% during the period. Food and fuel prices also saw noteworthy increases. 

"The details of the CPI paint a less benign picture. The tradables side was softer than expected, but the non-tradables component was stronger than forecast. The latter, where price pressures tend to be more persistent, is likely to carry more weight in the RBNZ’s thinking," says Michael Gordon, a senior economist at Westpac. "We think that OCR hikes are still some time away, but on balance today’s release weakens the case for the next move to be a cut." 

Markets care about the inflation data because it has a direct bearing on Reserve Bank of New Zealand interest rate policy. Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

The NZD/USD rate was quoted 0.64% higher at 0.6826 early in the London morning while the Pound-to-New-Zealand-Dollar rate was 0.49% lower at 1.9410. The Kiwi was also quoted higher against all other developed world currencies.

"We continue to see 'headline inflation' as a mythical beast, balancing opposing forces of 2-3%/y domestic inflation and largely negative tradable inflation over that time," says Annette Beacher, chief Asia Pacific macro strategist at TD Securities. "Not surprisingly, wages growth is marching higher. Along with the government's legislated push to have $NZ20/h minimum wages by 2020, staff at a retail warehouse chain was recently awarded a pay increase of up to 25% over the next two years as well as other benefits. Expect other industries to follow as employees are increasingly harder to find."

The Reserve Bank of New Zealand has held its interest rate at a record low of 1.75% ever since the end of 2016, citing below-target inflation, weak wage growth and a challenging outlook for the economy. Kiwi inflation has been below the midpoint of the 1% to 3% target ever since 2012.

Back in May, the RBNZ warned markets that interest rates are likely to remain at their current levels for "a considerable period of time," given the weakness of inflation and risks to the economy. This dealt a blow to the New Zealand Dollar, which is being increasingly undermined by interest rates that are no longer superior to those elsewhere in the world.

"Seemingly off the RBNZ's radar for now, inflation expectations according to the ANZ business survey has been hovering above 2% since late 2017 (June was 2.3%). The drivers behind these higher expectations have been in manufacturing and services, but construction is expected to join the uptrend as Kiwibuild competes for resources," says Beacher.

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates while providing insight into monetary policy, implies a cash rate below the current 1.75% in each month until August 2019, suggesting markets view an interest rate cut as more likely than an interest rate rise in the near future.

Any change for the better in this implied probability could provide the Kiwi Dollar with a powerful shot in the arm, given the extent of market pessimism toward the currency in recent months. But many analysts are still downbeat on the Kiwi.

New Zealand's Dollar has fallen by 4.7% against the US Dollar this year and by 2.2% against the Pound as the Kiwi interest rate outlook deteriorated, key agricultural commodity prices fell and the market's appetite for 'risk currencies' suffered in line with an increase in uncertainty over the outlook for international trade.

"New Zealand’s domestic economic picture continues to deteriorate. Weak business confidence suggests the softer undertones to the Q1 GDP figures are set to continue and the RBNZ has become incrementally more dovish. These domestic clouds are likely to continue to hang over the NZD and see it trade defensively," says Daniel Been, head of FX research at Australia and New Zealand Banking Group.

After rising sharply in the first-quarter, the Global Dairy Trade price index has fallen from 1,030 in April to a low of 986 in July. This move was driven by broad based declines in the price of whole milk powder, which is New Zealand's most important export, as well as milk fat, butter, cheddar and skim milk powder. This is a negative for the Kiwi.

Moreover, the so called "trade war" has seen fears of a global growth slowdown become more pronounced in recent months, which is bad for the Kiwi currency given its linkeage with commodity prices and global growth, given an escalating tit-for-tat tariff fight between the world's largest economies.

The White House is pursuing restrictive legislation to govern Chinese investments into the United States and recently ordered a range of tariffs be levied against imports of more than $250 billion in imports of Chinese goods. President Trump also placed tariffs on imports of steel and aluminium from China, Canada, Mexico and the European Union.

The EU has since responded with its own levies on US motorcycles, jeans and whiskey, drawing threats of even more tariffs from the White House, this time targeting the mighty European automotive sector.

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