Could the banking crisis ‘morph into something more sinister’ for the New Zealand dollar?

The New Zealand dollar has made a substantial comeback from decade-long lows against the American dollar in October last year, but the offshore banking crisis has put that recovery at risk. 

BNZ rate strategist Jason Wong said in a note on Monday that the outlook for the Kiwi dollar was split, depending on how the banking problems play out.

If concern for the banking system broadens, then the NZD could fall below US60 cents and towards last year’s low of about US55 cents. 

On the other hand, if confidence returns then the Kiwi should resume its upwards trajectory above US65 cents. 

The Kiwi dollar currently trades at roughly US62 cents, up more than 11% from October but down 2.5% since the start of the year. 

Wong said the NZD’s summer rally was supported by global economic growth upgrades, lower gas prices, and China’s exit from its zero-Covid policy. These conditions triggered a bounce for all types of risk assets, including the Kiwi dollar. 

However, Bloomberg reported last week that international traders were shorting the NZD as a hedge against another downturn in global economic outlook. 

JPMorgan Chase strategists were quoted as saying the Kiwi dollar tends to underperform its peers during recessions and was a reasonable choice to hedge macro conditions.

Traders often take refuge in the US dollar during times of economic crisis or uncertainty, which tends to push that currency upwards and the riskier currencies down.

In liquidity crises, specifically, the NZD has done very poorly. It plunged in both 2008 and 2020 during the global financial crisis and the Covid crisis.  

New Zealand’s economy is heavily dependent on commodity exports and is considered to be vulnerable to global growth cycles. JPMorgan said the Kiwi fared worse during historic US recessions than other developed peers and even some emerging market currencies. 

Short sighted sellers

Other analysts also have negative views on the currency, such as investment bank Morgan Stanley which last week recommended investors increase their short position on the NZD with a US58 cent target. 

BNZ’s Wong said the turmoil in the banking sector had increased market volatility and damaged risk appetite. But higher NZ to US interest rate spreads were supporting the NZD and preventing sharper falls. 

“Currency markets seem to have been less affected than rates, credit or equity markets, but the risk is that the situation morphs into something more sinister for commodity currencies like the NZD,” he said in a research note. 

Problems in the US banking system should not be underestimated, as there were less obvious risks than just the liquidity issues facing smaller banks — such as the leverage loan and the commercial property mortgage markets. 

“While we are optimistic that another global financial crisis is unlikely, it is patently clear that tighter lending standards will ensue,” he said. 

This could be equivalent to an additional 50 basis point rate hike and increases the likelihood of a recession in the US economy. Chair of the Federal Reserve, Jerome Powell said the crisis made the goal of a soft landing more difficult but said it was still possible. 

Wong said financial shocks are usually negative for the NZD and it was appropriate to lower BNZ’s forecast for the currency to factor in a weaker US economy.

The Kiwi may still continue to recover, but much slower than originally expected and it could easily fall if the banking crisis worsens. 

“Until the market gets more confidence that the US banking sector turmoil can be safely contained, a cloud overhangs the outlook that increases the range of possible outcomes in the months ahead.”

In the downside scenario, the NZD could “easily fall back” into its October low of US55 cents but it could also continue its climb towards US65 cents if the turmoil was quickly resolved. 

BNZ has reset its targets over the next two quarters to be between US63 to US64 cents, predicting a range of 61 to 66 cents and little chance of a break above 65 cents until year end. 

Current account considered 

New Zealand’s historically large current account deficit was another risk for the currency, but it wasn’t impacting the NZD yet. 

“Large current account deficits don’t matter for the market, until they do. The level of the deficit has got onto the radar of S&P regarding NZ’s sovereign credit rating, but that is about the limit of the attention it has got so far”.

The country’s current account deficit widened to $29.7 billion, or 8% of GDP, in the September year, prompting the credit ratings agency to warn it could lead to a downgrade from AA+. 

BNZ has forecast the deficit to get worse before it gets better, pushing well through 9% of GDP, with a risk of hitting 10%. Wong said annualising recent quarters already shows this level and could attract more negativity to the Kiwi dollar.  

“Rather than building in a view of the market “waking up” and selling the NZD at some point in time, we consider this variable as adding in some downside risk to our NZD projections.

The Institute of International Finance last year suggested the NZ dollar was 22% overvalued on a current account basis.