Exchange rate volatility; Irish budget, US tax breaks in focus

By Mike Jones

The NZD/USD opens this morning around 0.7600, pretty close to where it was this time yesterday. However, this masks some significant volatility through the overnight session.

Through the first part of night, the NZD/USD was underpinned by rising commodity prices and a broadly weaker USD. The USD lost part of its “safe-haven” allure as investors‟ risk appetite was bolstered not only by hopes Ireland would be able to implement its €6b austerity budget, but also US President Obama‟s plan to extend tax breaks for 2-years.

Global equity markets tracked higher, gold prices and oil prices surged to new highs and our risk appetite index (which has a scale of 0-100%) increased from 71.3% to 72.5%. Later in the night, the NZD surrendered all of its early gains as soaring US bond yields eroded part of the NZD‟s yield advantage.

Indeed, 10-year US Treasury yields jumped almost 20bps to 3.15% overnight. As a result, NZ-US 3- year swap spreads tumbled from 325bps to closer to 310bps, undermining the yield appeal of the currency.

From an overnight high of nearly 0.7660, NZD/USD was soon heading back towards 0.7600. It‟s worth noting, the recent narrowing in NZ-US interest rate differentials suggest some fundamental downside risks for the NZD/USD. Indeed, we warned of this risk as recently as last week (see NZD/USD: At the Mercy of Global Whims).

On their own, NZ-US 3-year swap spreads are consistent with a NZD/USD around 0.7300-0.7400, supportive of our view the risks around the currency are tilted towards the downside over the next month or so.

For today, updates on NZ Q3 manufacturing activity and building work put in place will help us finalise our estimate for Q3 GDP (which currently sits at 0.5%). It will also be worth keeping an eye on the newswires for any announcement regarding the passage of Ireland‟s fiscal austerity package. In the short-term, headwinds are expected on NZD/USD rallies towards 0.7650, with initial support expected around 0.7540.

Majors

Notwithstanding some intra-day volatility, most of the major currencies ended the overnight session not far from where they opened. The USD spent the first part of the night on the back foot. Investors‟ appetite for risk was supported by a couple of factors.

First, the Irish Times suggested Ireland would be able to pass a €6b austerity budget, thereby gaining access to the EU-IMF €85b bailout fund and averting the risk of a snap election. Easing fears about European sovereign solvency were reflected in modest declines in Spanish, Portuguese and Irish sovereign bond spreads.

Second, sentiment towards the global economy improved and global stocks rose after US President Obama revealed a plan to extend the Bush-era tax breaks for two years. European equity indices recorded gains of 0.7-1.6% while the S&P500 edged up around 0.5%, to the highest level since September 2008.

The VIX index (a proxy for risk aversion based on the volatility of the S&P500) slipped from above 18% to around 17.5%. Renewed optimism about the global economy and buoyant equity market sentiment encouraged investors to trim positions in “safe-haven” currencies like the USD and JPY.

USD/JPY climbed from around 82.50 to above 83.00 and EUR/USD rose from 1.3300 to nearly 1.3400. Commodity prices rallied strongly, reflecting the broadly weaker USD as well as firming expectations for global demand.

Gold prices briefly surged to a fresh all-time high of around US$1430/ounce and oil prices hit the highest level in over 2-years (above US$90.5/barrel). Still, later in the night, the USD began to unwind its early losses as „fundamental‟ support from rising US bond yields bolstered USD sentiment.

Indeed, 2-year US Treasury yields ended the night 6bps higher at around 0.51%, while 10-year yields jumped almost 15bps to 3.1%. Against the strengthening USD, EUR skidded from 1.3400 back towards 1.3300, AUD/USD slipped from above 0.9950 to below 0.9900, and USD/JPY extended its gains to around 83.30.

There was relatively little reaction to the Bank of Canada‟s decision to keep its policy rate on hold at 1% last night, as expected. The BoC noted recent economic developments have broadly fit with its expectations, but the risks around the global economy have increased. The CAD took the announcement more or less in its stride.

* Mike Jones is part of the BNZ research team. 

All its research is available here.