New Zealand Currency Intervention: Is it Enough to Kill the Carry Trade?

Having just hit a 22 year high, it is certainly surprising to see the New Zealand dollar down over 1.5 percent across the board. After raising interest rates to 8 percent last week, the last thing both analysts and traders expected was for the Reserve Bank of New Zealand to artificially weaken the New Zealand dollar by selling it outright in the foreign exchange market.

Not only is the impact of intervention completely inconsistent with the impact of an interest rate hike, this is also the first time ever that the RBNZ has intervened in the currency since it was floated back in 1985. The unprecedented move indicates that this is a very serious step for the central bank and not one that has been taken lightly. The next logical question to ask is whether the RBNZ will intervene again and if these moves are enough to kill the carry trade.

Before we attempt to answer these questions, it is important understand why they intervened in the first place:

Why Did the Reserve Bank of New Zealand Intervene?

NZD has become a one way bet

Over the past year, the New Zealand dollar has increased 26 percent against the US dollar and 32 percent against the Japanese Yen. As an export dependent country, the general fear is that the strength of the kiwi would take a big bite out of exports. Both RBNZ Governor Bollard and Finance Minister Cullen have repeatedly warned that the currency is extremely overvalued. Yet despite this strength, the RBNZ has had no choice but to raise interest rates. This year alone, they have already increased interest rates by 50bp and the interest curve is pricing in one and possibly even two more rate hikes by the end of the year. The reason why the RBNZ has been increasing rates is because they are mandated to keep inflation within a 1 to 3 percent range. Even though inflation has eased to 2.5 percent in the first quarter, domestic inflation which excludes import prices is still at 4.1 percent. This has made the New Zealand dollar a one way bet. Since the central bank still needs to raise interest rates to curb inflation, if they did not inject some sort of uncertainty into the direction of the currency, it would have most certainly hit 80 cents by the end of the year.

Strong NZD Hurts Industries

Even though we have yet to see a sharp deterioration in New Zealand data, it is only a matter of time till we do. Business confidence has already plummeted to the lowest level in over a year as the combination of a high currency and high interest rates force companies like Click Clack Ltd to shift its factories to China, and companies like Pumpkin Patch Ltd, the country?s second largest publicly traded retailer to report lower profits purely due to currency fluctuations. If the government allowed the currency to continue to rise, their local industries would suffer even more dramatically.

Perfect Timing

After the last interest rate hike, RBNZ Governor Bollard already expressed his dissatisfaction with the level of the NZD by stating that it was “exceptional and unjustified in terms of economic fundamentals.” However last night was probably the prefect timing for intervention. Australian markets were closed for the Queens?s Birthday which means that the central bank got the most “bang for its buck” with lower than average trading volume. Intervention is new for the central bank and particularly for Bollard since the country?s FX intervention policy was only amended in 2004.

How Effective is Intervention?

Psychologically, the threat of and outright intervention by a central bank always moves markets. Back in December 2005, the New Zealand dollar was trading at 72 cents. The central bank did not intervene but they did actively talk down the currency. In a matter of three months, the NZD/USD dropped below 60 cents. However, the effectiveness of currency intervention as a policy tool has been an ongoing debate within the financial markets and academia for years. The Bank of Japan has intervened frequently in the past to sell the Japanese Yen and quite often we have seen the currency just turn around and rebound. In the case of New Zealand, the effectiveness of their intervention is even more questionable. The “goal” or outcome of intervention is generally to increase the money supply, which effectively reduces interest rates. However the RBNZ clearly does not want interest rates to fall, in fact, they are expected to continue to raise rates going forward. Therefore it extremely likely that they will sterilize this intervention in order to neutralize the impact on the money supply. Sterilized intervention requires offsetting intervention with buying or selling of government bonds. By doing so, the intervention is less effective than unsterilized intervention and choosing this option suggests that the central bank is simply trying to send a message to the market rather than reverse the impact of its interest rate hike. Unless they intervene again, the effectiveness of this intervention will probably be limited.

Will it Kill the Carry Trade?

Although NZD/JPY is down quite a bit today, this may not be the end to the currency pair?s rally. It is estimated that Japanese retail investors hold about NZD18 billion of Uridashi bonds. Many of these bonds were bought at much lower levels and recently rolled over.
The interest payment on long NZD bonds is still very high so the currency would need to depreciate far further than 2 percent for these Japanese bond holders to start selling. NZD/JPY long positions are also off their highs which indicate that there could still be bargain hunters out there. In order for the carry trade to die, not only does the RBNZ need to intervene, but we also would need to see some action from the Bank of Japan.

Will there be More Intervention?

Westpac, one of New Zealand?s largest banks estimates that the central bank sold approximately NZD$120 million last night. The exact amount however will not be disclosed by the RBNZ until the end of July. To put this into perspective, when the Bank of Japan intervenes, they typically spend billions of US dollars. If the New Zealand dollar rebounds, further intervention is not out of the question, but it could be limited by the fact that New Zealand does not have much money to spend. Their intervention war chest is small. The special fund that they have set up for intervention only has approximately NZD7 billion or USD5.3 billion. The New Zealand dollar is not as liquid as the Japanese Yen so it takes less to move it, but at the same time, the RBNZ is new at intervening and they may find it extremely frustrating that the amount of money they have to intervene with is limited.

By Kathy Lien, Chief Strategist of