Interpretation of Orr's first MPS has been unrealisticaly conservative, ignoring the realities of our economy, says James Riley. The most likely direction of the NZD is up

By James Riley

The downward momentum in the NZD/USD exchange rate continued last week as the local FX markets decided to interpret the first Monetary Policy Statement from the new RBNZ Governor, Adrian Orr, as more dovish than anticipated.

The Kiwi dollar slid below 0.7000 following the RBNZ’s statement to a low of 0.6903 on Thursday 10th May.

In reality, the RBNZ economic commentary and outlook was not any different to their previous statements, with plenty of fence sitting in respect to future economic outcomes – the “on the one hand, however on the other hand” syndrome!.

The offshore forex markets adopted a slightly more positive view on the RBNZ’s assessment of the NZ economy. After plunging to a 0.6903 low on the day of the statement in NZ trading hours, the offshore markets were more interested to buy at the lower levels than to sell the currency lower. The subsequent trading sessions saw the Kiwi recovery back up to 0.6970. Heavy FX order amounts placed by local USD exporters with their banks between 0.7000 and 0.6900 would have added to the NZD buying volumes.

Why the local FX traders and bank economist would have interpreted the RBNZ statement as immediately negative for the Kiwi dollar seemed to hinge around the view from Mr Orr that there was an equal probability of the next change in the OCR being both up and down. Off course, what the next OCR movement is depends entirely on how the NZ economy performs over the next 12 months.

Even though the RBNZ see everything in the economy as being finely balanced, there is much less talk these days about global deflation, economic Armageddon, a Chinese economic implosion and the NZ economy being caught in the backwash.

For the next move in the OCR to be downwards, the economy would have to fall into a big hole with collapsing export commodity prices and construction activity coming to a shuddering halt. No-one is forecasting such a scenario for the NZ economy in 2018 and 2019.

The more likely scenario is that annual GDP growth eases from above the 3.00% levels we have enjoyed in recent years to around 2.00%. Not a large change and not enough to prevent annual inflation rising from its current 1.1% rate to just above 2.00%. How rapidly inflation lifts this year will determine in some part the fortunes of the NZD/USD exchange rate. A sharp move upwards in inflation this year cannot be ruled out with the recent dramatic increases in oil/energy prices and significant wage increases potentially occurring as a catch-up to the suppressed environment in recent years.

Governor Orr believes the financial markets view the business sector as continuing to look backwards at very low inflation and this is subduing their future price setting behavior. It is doubtful that business sectors across the economy are so backward looking in managing their profit margins. They are currently experiencing rising costs (e.g. fuel/freight) and it is only a matter of time before end-product selling prices are increased.

Therefore, even though GDP growth will soften a touch this year, the greater probability has to be that the next adjustment to the OCR interest rate will be upwards, sometime in mid-2019.

When the financial markets and the RBNZ realise that the balance is shifting to higher inflation, sooner than previously expected, the Kiwi dollar will receive support.

The timing of the aforementioned realisation by the FX markets will not be as late as mid-2019. The timing is more likely to be later this year, roughly at the same time the US political scene may be in some turmoil with the mid-term elections for the Senate (35 out of 100 seats) and House of Representatives (all 435 seats). The US dollar itself could be under downward pressure at this time due to political risk, interest rate hikes nearing their end and the budget deficit ballooning. A potential combination of a weaker USD on global FX markets and the local pundits looking ahead to a rising OCR in 2019 will result in the Kiwi dollar being pushed up to the 0.7500 area again.

Several local banks continue to publish forecasts for the Kiwi dollar depreciating to 0.6500 over the next 12 months. Such a scenario could only be caused by collapsing dairy prices to USD2,000/MT for whole milk powder and/or a much stronger US dollar. Both factors seem highly unlikely in my opinion.

The sharp five-cent fall in the NZD/USD rate from 0.7400 a month ago to rates in 0.6900’s today should not be ignored by USD exporters as a fortuitous benefit to cashflow and profits. They need to be hedging forward high percentages out to 24 months ahead to secure and protect their profit margins against future adverse FX market movements.