Opinion: NZ interest rates are unsustainably low, say NZ$ traders

By Roger J Kerr Volatility in the NZ dollar foreign exchange market just does not want to die down. International investor and currency trader interest in the Kiwi dollar is much reduced today compared to two to three years ago, and as a consequence market liquidity has also reduced. The wild daily and overnight swings in the NZD/USD exchange rate over the past 12 months have been partially caused by this reduced market liquidity. Relatively small real flow amounts and orders to buy and sell are having an exaggerated impact on the price as inter-bank players struggle to clear their risk into the fickle market. Adding to the liquidity issue has been material reductions in daily trading limits at the local banks and at the proprietary trading desks of global investment banks. It is hard to see the regular one to two cent daily trading ranges reducing until the market liquidity improves. Looking ahead it is hard to see what new and large capital outflows departing the NZD will be over the next 12 months. The maturing Euro-Kiwi and Uridashi bonds that will only be partially replaced by new issues are already well known and priced into the NZD market. Local fund managers are more likely to be reducing weightings to offshore investment and assets and increasing NZ weightings.

The NZ Super Fund should be receiving a Government directive soon to increase their NZ assets from the current 20% to 40%, a 20% local asset increase on the $11.5 billion fund calculates to NZ Super effectively buying NZ$2.3 billion of NZ dollars in the forex market. There are also several reports of offshore investors taking advantage of the lower NZD value to buy into depressed property values here. Profitability of overseas-owned businesses in New Zealand will be down significantly this year, resulting in reduced selling of NZD's to send profits home and a decrease in the Current A/c deficit as liabilities to overseas parties also reduces. It is certainly easier to identify several capital inflows than any large-scale capital outflows. Interest rate differentials loose their potency? (for the meantime!) The appreciation of the NZD from 0.5600 to above 0.6000 since the 0.5% reduction in the OCR to 2.5% by the Reserve Bank on 30 April has many market observers puzzled. The party who will be the most perplexed will by the RBNZ themselves, as their statements and actions of late have been designed to push the Kiwi dollar down as they view recent currency gains as inconsistent with where they want monetary policy (i.e. monetary policy is not as loose as they desire). However, their control of short-term, inter-bank, wholesale interest rates is only one of many forces that drive the NZ dollar exchange rate value in the marketplace. The current NZD/USD rate at 0.6000 has diverged from where the 90-day interest rate gap would price it at 0.52/0.53. The other forces at work in the short-term that have over-powered the interest rate differential correlation factor have been:-

• The AUD has strengthened against the USD due to no further cuts in their interest rates and rising hard commodity prices.
• Gains on global sharemarkets as US economic data improves and risk aversion levels of investors reduce.
• Stabilisation in NZ commodity prices over the last three months, defying earlier forecasts of these prices continuing to plunge this year.
• Improvement in consumer and business confidence indices over recent weeks, indicating that the economic recession is not deepening or lengthening and maybe already past its worst point.
• Weaker USD on global currency market as the Europeans deny (for the meantime) the reality that they have to cut their interest rates further.
• Official short-term interest rates may be 2.5% in New Zealand, but banks are paying closer to 4.00% for retail deposits and even higher for offshore wholesale funds. The real interest rate market where investors and borrowers are meeting each other on price is considerably higher than 2.5%. The FX markets are reflecting this reality.

The FX markets, in pricing the NZD/USD rate to 0.6000 are effectively saying that NZ interest rates are unsustainably low and that the gap to the US interest rates will increase over time. In the short-term the NZD/USD may pull back below 0.6000 as it appears that the recent AUD gains against the USD are "too far, too quick" from 0.6500 to 0.7700. Longer-term, both exporters and importers should be factoring-in a NZD/USD rate above 0.6000, rather than below 0.6000. "”"”"”"”"”- * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com