China cutting rates rather than RRR signals seriousness of slowdown in economy

by Mike Jones

NZD

The NZD/USD has spent the past 24 hours trading choppily inside a 0.7680-0.7750 range.

There’s been plenty of news and events for currency markets to absorb over the past 24 hours. Broadly speaking, the good has cancelled out the bad to leave most of the major currencies close to levels prevailing this time yesterday.

Yesterday’s stellar Australian employment data carried on this week’s glory run for the Aussie economy. A whopping 38.9k jobs were added in May (against analyst forecasts for 0.0), casting more doubt on market expectations for aggressive RBA easing in coming months.

The AUD/USD and Australian swap yields continued on a path higher in the wake of the numbers.

It’s worth noting, this weeks strong Australian data and sell-off in Aussie swap yields has dragged NZ yields substantially higher. The 2-year NZ swap rate, at 2.55%, is some 20bps higher than where it started the week.

Expectations for RBNZ easing over the coming 12 months have been pared back from 45bps to ‘just’ 20bps. This is testament to the (undue) influence of Australian market pricing on NZ.

We think there are sufficient differences between the NZ and AU economies to prevent the RBNZ from following the RBA and cutting rates next week.

Egged on by the strong Aussies job numbers, the NZD and AUD started  the overnight session on the front foot. A surprise Chinese rate cut then juiced up risk appetite and equity markets, paving the way for another strop higher in the NZD/USD.

However, the currency’s highs around 0.7750 didn’t last for long. Fed chairman Bernanke put the kibosh on market hopes for an imminent Fed easing, causing the USD to reverse some of its earlier losses. The NZD/USD was knocked back to around 0.7700 in the wake of the strengthening USD.

For today, the NZD will continue to look across the Tasman for direction. Australian trade balance figures should be glossed over in favour of a speech from RBA Governor Stevens around 3:30pm (NZT).

Expect the NZD/USD to close out the week inside the familiar 0.7660-0.7750 range. The chances of some weaker Chinese data over the weekend (following last night’s rate cut) could make for an interesting/volatile Monday open.
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Majors

It’s been a whippy night in currency markets, ending with little net change. The USD index was tossed around in a 81.90-82.40 range, finishing the night marginally weaker.

The USD started the night on the back foot as risk appetite continued to gradually recover. The May UK services PMI looked encouraging (53.3 vs. 52.4 expected) and the Bank of England kept rates and asset purchases unchanged as expected.

But the real kicker for risk sentiment came from an unexpected Chinese rate cut. The PBOC cut 1-year deposit and benchmark lending rates by 25bps, the first such cut since 2008.

The fact the PBOC is now using rate cuts rather than RRR cuts to boost the economy perhaps underlines the seriousness of the slowdown. The timing of the move may also indicate this weekend’s slate of Chinese data (retail sales, trade balance, industrial production) could be weak. However, the knee-jerk reaction in markets was positive.

Most commodity prices opened up stronger and global equities extended Thursday night’s gains. Speculative long positions in the ‘safe-haven’ USD were further trimmed, sending the EUR/USD and AUD/USD to overnight highs around 1.2620 and 1.000 respectively. Asian currencies such as INR and KRW also pushed higher in the wake of the Chinese cut.

Later in the night, the USD bounced back after Fed Chairman Bernanke disappointed a market intent on additional quantitative easing (QEIII). For now, it seems the Fed is keen to keep its powder dry in case the European crisis deteriorates (“prepared to take action if stresses escalate”). As markets priced out an imminent Fed easing, the USD was pushed higher, knocking the major currencies off their earlier highs.

So who should have the weaker currency? The US economic recovery has undoubtedly lost steam, inflation is subdued, and the prospect of QEIII may keep the USD heavy.

On the other hand, the European recession is deepening, the ECB has left the door open to rate cuts, and Grexit fears and the Spanish banking crisis are unlikely to go away anytime soon – all stiff headwinds for the EUR. These conflicting influences may keep the

EUR/USD choppy and range-bound until it becomes clearer which side of the Atlantic is in more dire straits. We look for a 1.2420-1.2820 near-term range.

Tonight, there is little data on the agenda. But the weekend’s Chinese data feast looks set to spur some volatility at the Monday open.

All its research is available here.