New Zealand Dollar Could Decline as Carry Trade Outlook Sours

[B]New Zealand Dollar Could Decline as Carry Trade Outlook Sours[/B]

[B]Fundamental Outlook For New Zealand Dollar: [/B][B]Bearish[/B]

The New Zealand dollar finished the week marginally higher against its US namesake, but a general pullback in global risk sentiment and disappointing domestic economic data leave NZD risks to the downside through coming trade. Financial markets remain largely directionless, but we believe that there are significant risks that equity markets and forex carry trades topped in the month of June. The implications for the New Zealand Dollar are clear: significant deterioration in market risk sentiment could lead to a noteworthy NZD/USD and NZD/JPY reversals.

Domestic economic developments have proven largely disappointing, and we maintain a negative fundamental bias on the New Zealand dollar. Recent Gross Domestic Product figures showed that the economy contracted for the fifth-consecutive quarter—the worst stretch since official records began in 1977. In fact, GDP numbers could have proven worse had it not been for a sharp improvement in the domestic trade balance. The perpetually outsized New Zealand Current Account deficit shrunk to -1.24B NZ$ in the first quarter from -4.06B in Q4, 2008. The contraction was ostensibly encouraging but came on 21.9 percent tumble in imports—hardly a sign for increased demand for the New Zealand Dollar. In fact, the sharp decline in imports emphasizes that domestic demand remains weak and limits scope for a turnaround in consumption.

The economic calendar is relatively empty for the week ahead, but attention will once again turn to consumption as markets await the results of Trade Balance and Consumer Confidence figures. The former has historically forced noteworthy volatility in NZD pairs, but more recent releases have hardly influenced the NZDUSD and NZDJPY. It may be far more important to watch general trends in global risky assets and carry trade demand. Though aggressive Reserve Bank of New Zealand interest rate cuts have greatly reduced carry-linked demand for the Kiwi, it nonetheless boasts a 2+ percentage point yield advantage over the US dollar and Japanese Yen. In a world of compressed market returns, risk-seeking investors are once again building positions in the carry trade. A downturn in risk sentiment could easily reverse gains in the NZD, and it will be critical to watch for early warning signs of a true carry trade turnaround. - DR