The New Zealand Dollar Crumbles after RBNZ Shocks Market with End-2020 Interest Rate Forecast

-NZD crumbles as RBNZ shocks markets with interest rate forecast.

-RBNZ bullish on economy but to leave rates at 1.75% until end of 2020.

-Forecast crushes hopes of 2019 rate rise and badly bruises the NZD.

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The New Zealand Dollar crumbled Thursday after the Reserve Bank of New Zealand (RBNZ) told markets that interest rates will remain at a record low for longer than even the most downbeat of analysts had previously anticipated.

RBNZ governor Adrian Orr held Kiwi interest rates at a record low of 1.75% for August on Thursday and said the bank expects it to remain there throughout 2019 and into the third quarter of 2020. Markets had been looking for an interest rate rise to come around the middle of 2019.

This was despite the governor also issuing an upbeat assessment of New Zealand's economy while cheering a recent improvement in the Kiwi inflation outlook. If anything, those factors would typically mean an interest rate rise becomes more likely, not less. 

"The RBNZ has now accepted that economic growth is falling short of its bullish forecasts. Consequently, they have pushed out the expected date for OCR hikes," says Dominick Stephens, chief economist at Westpac. "The intensity of the RBNZ’s reaction today to the slowdown in growth surprised us and financial markets." 

The governor said Kiwi growth should pick up pace later this year and maintain its newfound momentum into 2019. He also forecast inflation pressures would continue to build over coming quarters, albeit in a manner that leads to a bumpy path higher for the consumer price index. 

Stephens says Thursday's statement means the Westpac team are pushing back their long-held forecast for a Kiwi rate rise in late 2019 out into 2020. They had previously been among the most downbeat in thier outlook for Kiwi rates.

"The New Zealand dollar is by far the worst performing G10 currency versus the dollar this morning," says Derek Halpenny, European head of global markets research at MUFG. "Incredibly, the RBNZ pushed the timing out to Q3 2020, a full year further out than what was indicated in May. Looking back through the data it is hard to understand exactly what has driven such a shift in thinking."

The NZD/USD rate was quoted 0.58% lower at 0.6654 Thursday and is down 6%% in 2018, while the Pound-to-New-Zealand-Dollar rate was 0.40% higher at 1.9316. The AUD/NZD rate was 0.50% higher at 1.1149 and is up 1.17% this year. Some strategists say it could now move much higher over coming months.

"This dovish shift in the RBNZ’s projected OCR path was enough to see NZD/USD take out the 0.67 support – with the 2Y NZ swap rate falling +10bps. While we may see further kiwi weakness today – as markets adjust to a central bank that has no appetite to hike – we note that there is hardly any tightening now priced in over a 2-year horizon. This may limit NZD/USD’s downside pain to 0.6600/50," says Viraj Patel, a currency strategist at ING Group.  

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.

New Zealand inflation rose by 0.4% during the second quarter, down from the 0.5% seen in the previous quarter. 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 number was in line with RBNZ forecasts although the core number took the market by surprise.

Moreover, the RBNZ's own survey of inflation expectations for the second quarter, released Wednesday, also showed consumer price pressures beginning to build in New Zealand. Survey respondents saw inflation anchored around 2% over coming years. This is right at the midpoint of the RBNZ's 1% to 3% inflation target. 

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, which has been fulled by years of weakening wage growth.

Consensus had been for the central bank to keep rates here until some time in the second-half of 2019, although markets have recently begun to speculate about the possibility of an interest rate cut.

"The RBNZ is not giving investors any reason to hold NZD. With the US having a higher (and rising) cash rate compared with the RBNZ, the 'carry' incentive doesn't apply either. We are not dovish, therefore 'hawkish'," says Annette Beacher, chief Asia Pacific macro strategist at TD Securities.

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 June 2019.

This suggests markets view an interest rate cut as more likely than an interest rate rise in the near future and that, under any circumstances, rates will not rise for quite some time to come. 

That policy stance, at a time when central banks in the US, Canada, UK and elsewhere are raising their own interest rates, has incentivised investors to sell the Kiwi Dollar in favour of buying Pounds, US Dollars and other currencies.

Accordingly, the Kiwi Dollar has ceded ground to all but two of its G10 rivals in 2018 and some analysts forecast even further losses are still to come.

"The Australia-New Zealand two-year swap spread has moved into positive territory for the first time in five years," says Richard Grace, chief currency strategist at Commonwealth Bank of Australia. "The two-year swap spread is now indicating a greater level of confidence that Australian interest rates will be higher than New Zealand interest rates over the next two-years. This development should generate a further modest upward valuation adjustment in the AUD/NZD exchange rate."

Grace says the 2-year swap spread, which is the diference between implied rates in the interest rate derivatives market measured in basis points, has not been the greatest indicator of AUD/NZD direction over recent years but that it is worth watching because the early 2015 exchange rate low also coincided with the "cyclical low" in the swap rate. He forecasts a 1.10 to 1.12 trading range for AUD/NZD over coming months, the top end of which would put the exchange rate at a 2018 high. 

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