New Zealand Dollar Set for "Tactical Outperformance" as Inflation Puts RBNZ in the Spotlight

-NZD on cusp of "period of tactical outperformance" say ING.

-NZD to notch up sustained gains say RBC Capital Markets.

-Sell AUD/NZD say both ING Group and RBC Capital Markets.

© Comugnero Silvana, Adobe Stock

The New Zealand Dollar posted a chequered performance amid risk-off trading Monday but, according to one strategist, the Kiwi is now on the cusp of a period of "tactical outperformance" in the wake of last week's inflation numbers.

Inflation rose by 0.4% during the second quarter, down from the 0.5% seen in the previous quarter and below the 0.5% forecast by economists. But core inflation, which removes extreme price movements as well as some volatile commodity items from the goods basket, rose to 1.7%. 

The main consumer price index number was in line with the Reserve Bank of New Zealand forecast although the core number took the market by surprise, leaving many analysts with little choice but to conclude that inflation pressures are recovering in New Zealand. 

This is a milestone development that could potentially have a significant impact on the Kiwi currency for some time to come. Not least of all because of the damage wrought on the Kiwi this year by the RBNZ stance on interest rates, the outlook for which has become more positive in the wake of last week's data. 

"The fundamental NZD outlook turned slightly favourable this week after the RBNZ’s core inflation measure (sectoral factor model) moved up to 1.7% YoY in 2Q18 (which is a 7-year high)," says Viraj Patel, an FX strategist at ING Group, in a note last week. 

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.

RBNZ Governor Orr warned in May that interest rates will remain at 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.

"The positive inflation surprise coupled with a flat NZD OIS curve (limited RBNZ tightening sentiment), short NZD/USD speculative positioning at 5-year lows, signs that the USD may be turning lower and a potential pause in trade war risks means that we see room for short-term tactical NZD outperformance," Patel adds. 

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.

Kiwi interest rate expectations have been strumming along the bottom a proverbial barrel for much of 2018, while markets are increasingly contemplating how high US interest rates will go, as well as when the next rate hikes will come from central banks in the UK and Canada.

This driving the New Zealand Dollar, which used to benefit from interest rates that were typically higher than those elsewhere in the world, to a 4% loss against the US Dollar and close to a 2% loss relative to Pound Sterling. 

"Given the volatility and uncertainty of US trade policy - and the potential for an escalation in the global trade war narrative - we prefer to play NZD strength against AUD and CAD (both more vulnerable to US tariffs)," Patel concludes.

Financial market unease over President Donald Trump's "trade war" has helped prop up the US Dollar of late while driving so called risk currencies, like the Australian Dollar, to new lows.

This may see gains for the Kiwi currency tempered when it is stood next to the US greenback but may also give the New Zealand Dollar an edge over its riskier rival, the Australian Dollar. Patel is not alone in viewing the NZD/AUD, or the inverse AUD/NZD, rate as an opportunity. 

"With fundamental news flow quite light this week and headline risk high, we prefer trades that are neutral to risk appetite and to general USD direction and AUD/NZD satisfies both criteria. With AUD/NZD close to the top of its six month range, but technical signals turning bearish (double top put in place earlier in July), we take the opportunity to express our medium-term positive NZD view," says Adam Cole, chief currency strategist at RBC Capital Markets. 

Cole and the RBC team advocated on Monday that clients of the bank bet on a fall in the AUD/NZD rate. They have entered the trade themselves at the 1.0885 level and are looking for a move down toward 1.0680 during the weeks ahead.

The trade comes ahead of Wednesday's second quarter inflation numbers from Australia that will either add further to the Aussie's woes, which have been similar to those of its Antipodean cousin, or help to pare back steep losses wracked up in the last three months. 

The NZD/USD rate was quoted 0.12% lower at 0.6788 Monday while the Pound-to-Kiwi rate was 0.40% higher at 1.9317. The AUD/NZD rate was quoted 0.19% lower at 1.0878. In fact, the Kiwi fell against all developed world currencies Monday, other than those flagged last week by ING's Patel. 

Cole and the RBC team forecast the NZD/USD rate will finish the 2018 year at 0.70 but that the Pound-to-Kiwi rate will fall all the way to 1.7142 by this time. The AUD/NZD rate is forecast to fall from 1.08 to 1.00 by year-end. 

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