New Zealand Dollar at 25 Year Highs: Can the RBNZ Really Raise Rates?

The New Zealand dollar is trading at 25 year highs going into Wednesday?s Reserve Bank of New Zealand monetary policy meeting. Only a year ago, these meetings passed with hardly a glance from most market participants. However, at the beginning of this year everything changed when Governor Alan Bollard decided to rein in inflation.

Under the Policy Target Agreement, the central bank?s main charge is to keep medium-term inflation between 1 and 3 percent. Bollard clearly took his duties seriously as he proceeded to raise the overnight cash rate by 25 basis points at three consecutive meetings beginning with the March gathering. Before this string of hikes, the benchmark rate was last changed back in December of 2005. This momentous change in policy stance has clearly been taken notice of by a market that has become increasingly infatuated by the carry trade and its easy and seemingly consistent returns in a high liquidity period where alpha seems ever more difficult to capture. With interest rate spreads still the topic of conversation in most FX trading circles, there is little doubt that this RBNZ rate decision will draw interest from every corner of the market - from those looking to merely stay on the right side of the carry in majors like NZDUSD and those concentrating explicitly on the yield differential from pairs like NZDJPY.
[B]Where Do The Market Participants Stand?[/B]
Often times, when speculating on the release of a big economic indicator, economists and traders will have divergent forecasts. However, for the New Zealand central bank?s July 25th rate decision, both sides are preparing for a fourth, quarter-point rate hike that would lift the main lending rate to a new nine-year high of 8.25 percent. The futures market is currently pricing in a 70 percent chance of a hike, which is a much more unanimous view than the speculation leading into the March 8th and April 26th rate decisions. Looking at the ‘official? consensus of economists or analysts, expectations for a hike are just as strong. Bloomberg?s survey shows that 12 of 16 economists (75 percent) surveyed are also calling for a hike.
[B]Will Finance Minister Cullen Stand in the Way?[/B]
Although there is a consistent and strong call for a fourth rate hike, there are more than a few convincing arguments against such an aggressive move. The first and most obvious is inflation itself. The government established a 1 to 3 percent tolerance band for annual price growth back in 1989. While there may be obvious threats to a rebound in the future, the benchmark CPI indicator has already fallen back to a 2.0 percent annual pace through the second quarter. Furthermore, the gauge has been within its self prescribed limits since the final quarter of last year. Inflation aside, the biggest problem with raising rates is the level of currency. While the steady rise has been a boon for some currency traders, it is unwelcome almost everywhere else. From outside the country, the outcry against one-way bets in the carry trade has grown in Japan, the US, and the Euro Zone and among others. Governor Bollard himself has made clear attempts to talk the currency down earlier this year and last. He upped the ante when he intervened in the FX market by selling New Zealand dollars from the bank?s reserves. So far none of these efforts have born fruit. Finance Minister Michael Cullen may have drawn the line in the sand. In a statement delivered to parliament last week, Cullen ‘reminded? those in attendance (the media included) that he has the power to alter the RBNZ?s objective for monetary policy - from being solely focused on inflation to perhaps include a clause for growth. It will be interesting to see how this plays out in the future.
[B]Effects of A Hike On The Economy[/B]
While those holding long New Zealand dollar positions this year have enjoyed strong gains thanks to the three previous rate hikes, the level of the lending rates and subsequent effect on the currency has, and will continue to, exact a heavy burden on other parts of the economy. Perhaps the most remarkable relationship for the economy is that high interest rates divert consumers? income away from discretionary spending. In fact, this is exactly what Governor Bollard has wished to accomplish in this recent spat of rate hikes. Since turning from a cautiously hawkish stance to pursuing actual hikes, Bollard has warned that he would pursue further rate tightening until consumer spending and housing demand subside. Thus far, it is clear that neither has cooled sufficiently. On the other hand, should the monetary policy authority continue to lift rates, it will eventually cull New Zealanders willingness to spend. At some point, mortgage payments and credit card rates will sap incomes. And, as the RBNZ Governor focuses his attention on the consumer, the business sector will continue to suffer. Factory owners are paying doubly through high lending rates and unfavorable exchange rates that have cut into demand for the nation?s exports.
[B]Effects of A Hike On The Currency[/B]
The possible effects on the economy of further monetary policy tightening are convoluted and mired with uncertainty; however, the likely outcome for the currency is rather clear cut. Should the nation?s overnight lending rate be lifted to 8.25 percent, it would exacerbate already wide yield differentials across the FX spectrum and offer even more appetizing returns for currency traders. The spread with the US interest rate would widen to 3.00 percent and with the popular Japanese lending rate, it would balloon to 7.75 percent. What?s more, both of these popular counterparts are expected to remain relatively steady through the near future. For the exchange rates themselves, it would not be difficult for an influx of carry trade capital into the New Zealand currency to bring the NZDUSD to 0.85 and NZDJPY to 100.00. However, there may yet be a caveat to this otherwise clear correlation. Should Bollard hike and then indicate that he would not raise rates further, it would end the central bank?s tightening cycle and take some steam out of the currency?s rally.

[B]What If Bollard Doesn?t Hike?[/B]
But what if Central Bank Governor Bollard gives into the pressure by Finance Minister Cullen and decides not to raise rates? The reaction in the currency will depend upon the signal that he gives about monetary policy in the months to come. A pass accompanied by a change in sentiment to a more neutral (or dovish) tone would certainly strike fear into the hearts of the extant carry trade crowd. A considerable correction would not be unusual in such a situation. On the other hand, a pass with the door being left wide open for possibility of further hikes would likely see only modest losses. Given recent data and currency movements this could be a very likely possibility. In that case, any dip in the New Zealand dollar may just be seen as another buying opportunity.