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Interest Rate Market Commentaries - Weekly

The debate that rages in the US economy between the financial/investment markets and the Federal Reserve is whether the softer economic/inflation data recorded through the April/May period is merely temporary (the Fed’s view) or permanent (the market’s view). Latest US economic data suggests that the Fed are on the right track and the markets will soon be forced to change their outlook.

Here in New Zealand there is also a massive divergence in view between the financial markets and the central bank. The RBNZ have stated that they see the sudden and sharp increase in inflation during the March quarter as a temporary blip that will quickly right itself with prices in the economy decreasing from the current 2.2% annual inflation rate. A major cause of the inflation increase over the March quarter was higher food prices, particularly fruit and vegetable prices. Food prices continued to increase through the April and May months as adverse climatic conditions reduced the supply of fresh vegetables. We will see what happened with food prices in June with the release of the Food Price Index this Thursday 13 July. Anecdotal evidence from those doing the weekly supermarket shop suggests that prices have stayed up or have moved even higher. No evidence at all of the RBNZ’s anticipated quick reversal in the March price spike. What has moved in the RBNZ’s favour is lower oil prices feeding into lower petrol pump prices with the NZD/USD at the upper end of its trading band aiding the fuel price declines.

The debate here is if and when will the RBNZ be forced to change their forecast of inflation reducing to 1.1% by March 2018? The RBNZ’s current forward guidance is that there will be no OCR change until 2019. The local short-term interest rate market is pricing the first OCR increase in May 2018 and another 0.25% lift in September/November. A fall in the exchange rate TWI Index to well below the 76.00 level the RBNZ apply for their current inflation forecasts would certainly cause a RBNZ revision. However, right now the TWI Index remains well above the expected track at 78.25. Whether RBNZ monetary policy changes and signalling is affected by the change in Governor to Grant Spencer for an interim period of six months from September is also a matter of some conjecture.

The June quarter’s CPI inflation release in Tuesday 18 July may well hold the key to whether inflation is reversing back down again or staying up. The RBNZ forecast is for a +0.30% increase, leaving the annual rate at +2.10%. If the actual result is well above the +0.30% forecast it is going to take some flat to negative quarterly price changes over the remaining three quarters to reduce the annual inflation rate to 1.10% level by March 2018 as the RBNZ forecast. My view is that crude oil prices would need to fall to well below US$40/barrel to have any chance of the RBNZ inflation forecast being accurate. I just do not see that happening anytime soon.


US Fed correct on economic outlook: US dollar should recover

The Mexican stand-off between the US Federal Reserve on the one side with a programme to increase their interest rates by four 0.25% increments (a 1.00% lift) over the next 18 months, and the US short-term interest rate market/US dollar forex market, on the other side, who are only pricing in one 0.25% increase over the same period must resolve itself one way or the other very soon. Who is right and who is wrong will be revealed by either the Fed changing its view or the markets changing their forward pricing. What will determine the outcome is, off course, the strength or otherwise of US economic data that drives the inflation rate. After a soft patch of data through the US Spring period (April/May) the markets believe they are on the right track as they see these weaker economic numbers continuing. On the other hand, the Fed are adamant that the softer Spring data was purely temporary (“transitory”) and the inflation rate will start to trend upwards again.

Underpinning the Fed’s stance is Janet Yellen’s plan to return US monetary policy to “normal” conditions so that she has the ability to cut rates if she needs to assist the economy in the event of an unexpected economic downturn. Over this last week, US economic data has supported the Fed’s view with the ISM manufacturing survey on forward orders moving strongly higher and Non-Farm Payrolls, the monthly employment measure for June posting a very robust 220,000 jobs increase (well above prior forecasts). We must be close to the point where the short-term interest rate market in the US concedes defeat in their stance and starts to price in a more increases in 2018. The US Treasury Bond market seems to be backing the Fed’s economic and inflation outlook with the 10-year bond yields increasing from 2.15% to 2.40% over the last fortnight.

Why the US dollar FX market has not followed the US bond market and sent the USD on a strengthening path (due to rising US interest rates) is more about what has happened in Europe with monetary policy signals, than US developments. The EUR/USD exchange rate remains at $1.1400 with the US dollar fall from $1.10000 due to the ECB messaging that they are coming to the end of their “easy, easy” monetary policy settings and see reflation ahead rather than continuing deflation. The overall value of the US dollar on their currency index has depreciated to 96.00 as a result. Continuing US dollar weakness cannot be expected if the Fed proves to be correct in their outlook and the US short-term interest rate market starts to price in more increases. In any case, the ECB seem to be already regretting the signal they provided to the markets or the market’s miss-guided interpretation of their rhetoric. A reversal of the USD’s fortunes back to $1.1000 against the Euro over coming weeks will be one factor that causes the NZD/USD exchange rate to return to the 0.7100 area from the current 0.7300 level.

The Kiwi dollar in its own right has run into something of a brick wall at 0.7300 against the USD with currency speculators clearly not prepared to buy more Kiwi dollars at this level to push it higher. However, it requires a catalyst to spur selling activity to send the Kiwi dollar lower. Just what that negative catalyst will be remains to be seen. It will not be any local economic developments or our commodity price changes as they both remain very positive. The potential negative shock for the Kiwi dollar is much more likely to come from the US, with the Trump administration’s report on import tariffs and trade protectionism due for release any day now. The FX markets reacted instantaneously to sell the Kiwi aggressively back in late April when President Trump tweeted that dairy imports could be added to his 20% tariff on Canadian lumber imports. New Zealand does not export dairy products to the US, however as a major dairy exporter it was seen as negative for us by sheer implication. Any mention of import tariffs on agricultural goods in the Trump trade report will push the Kiwi dollar down.

Whole milk powder commodity prices are now stabilising around the US$3,100/MT mark and should remain close to these levels over coming months. Dairy commodity price movements will therefore will have no real influence over the NZD/USD exchange rate direction. Mining and metal commodity prices are however recovering from recent falls, thus the FX markets are likely to favour the AUD over the NZD over coming weeks/months which will force the NZD/AUD cross-rate lower from its current 0.9550 rate.