Roger J Kerr says part of the explanation for the recent NZ dollar stability in the face of a stronger US dollar and weaker global equity markets, is the expectation of a change of Government

Summary of key points: -

• The NZ Dollar displays its growing resilience
• Rout in US Treasury Bond market causes carnage – will it continue?
• Permutations for the Kiwi dollar on the election result

The NZ Dollar displays its growing resilience

Over the last month the US dollar has appreciated by 2.60% against all currencies (per the USD Dixy Currency Index) from 104.17 in early September to a high of 106.86 on 4th October 2023.

The US dollar has been in demand due to sharply rising US bond yields, speeches from Fed members on monetary policy settings still being on the hawkish side and marginally stronger than expected US ISM manufacturing survey data for September.

Over that same time period the NZD/USD has continued to trade between 0.5880 and 0.6050 (briefly touching both extremities but reversing back each time). The Kiwi dollar has not been sold down with other currencies against the USD over this period and has been very stable most of the time between 0.5900 and 0.6000 (refer to chart below).

Rout in US Treasury Bond market causes carnage – will it continue?

There is much more to the spectacular sell-off in US Treasury Bonds over the past month than insufficient investor demand not matching the increase of new bonds being issued (supply) by the US Government over this period. The substantial increased amount of supply through the September and December quarters has been known about for some months now and was behind the increase in 10-year bond yields from 3.80% in June to 4.20% August. However, the continuation of the heavy selling of bonds over recent weeks to 4.80% has been prompted by other variables and market forces.

The prime reason for the additional bond selling would be the market’s response to the individual members of the Fed’s monetary policy committee increasing their “dot-plot” interest rate forecasts for 2024. More Fed members now foresee the Fed Funds interest rate staying above 5.00% through 2024 than previously forecast. Leveraged and speculative bond traders/hedge funds have laid down new bets in the market over recent weeks that these interest rate forecasts will be proven accurate as we move through next year. For the interest rate forecasts to be proven accurate and the bond market punters therefore to be right, US inflation would need to start increasing again at an alarming rate.

The probability of US inflation increasing from an annual rate in the 2.00% to 3.00% region in late 2023 to above 4.00% in 2024 seems highly unlikely (in this writer’s humble opinion). It is difficult to see which component parts of the US’s goods and services prices will reverse out of their current downtrends and zoom upwards in 2024. The global shipping/freight prices are back to pre-Covid levels, wage growth is trending downwards, and rents/housing costs are now falling rapidly on their 12-month lag.

The bond selling that has sky-rocketed the 10-year yields to 4.80% cannot be related to expected future inflation levels. Therefore, it has to be highly speculative in nature, more related to numerous CEO’s of US investment banks boldly predicting that bond yields will need to increase to above 5.00% and 6.00%. Investment market veterans/cynics will detect that these investment banking chaps always “talk their book” and it is all about their own bank’s bond traders having extreme market volatility to make money on short-selling the bonds.

The bond market carnage that has increased US 10-year yields to 4.80% is extremely damaging to economies, investors, borrowers and equity markets around the world. The bond selling being   highly speculative/leveraged means that anything could trigger a dramatic reversal to lower yields as the ‘short-sold “ positioning is unwound. A strong candidate for the reversal trigger would be actual US inflation results printing much lower than forecast. Core and headline inflation increases for the month of September on Friday 13th October that are less than the +0.30% expected could well be that trigger.

As the sell-off of the bonds has been speculative and not based on economic fundamentals, it will prove to be temporary. Very much like to recent rapid increase in crude oil prices from US$70/b (WTI) to above US$93/b due to the OPEC producers reducing supply. The oil price has abruptly reversed to below US$83/b over this last week as supply is added (attracted by the higher prices) and demand decreases on slower economic growth.

The USD Dixy currency index has followed the bond yields higher over the last three months (refer chart below). Both increases appear over-cooked and therefore prone to sharp reversals back down. The USD Index back to 100 would propel the NZD/USD rate to above 0.6300.

Permutations for the Kiwi dollar on the election result

Part of the explanation for the recent NZ dollar stability in the face of a stronger US dollar and weaker global equity markets, is the expectation within the forex markets that there will be a change of Government in New Zealand this Saturday and that change is certainly not a negative for the Kiwi dollar. Therefore, a clear-cut, centre/right victory for National/ACT is largely already priced into the NZ dollar value at 0.6000.

Based on how potential alternative political outcomes will impact New Zealand’s economic performance going forward (due to different economic policy prescriptions), the likely response by the FX markets is as follows: -

• National/ACT coalition: More fiscal discipline and business friendly = NZD up.
• National/ACT coalition with supply support agreement with NZ First: as above = NZD up.
• National/ACT/NZ First coalition: As above, but more disruption from Winnie = NZD stable.
• Labour/Greens/Te Pati Māori coalition: Continuation of weak fiscal discipline = NZD down.

Protracted political party negotiations after the election to form a Government will be destabilising and will not allow NZ dollar gains until a clear mandate is formed.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.