During the third quarter, the New Zealand dollar once again achieved the role of biggest market mover. However, whereas this title referred to astounding gains made through the first half of the year, this past quarter’s increase in FX volatility opened the door to a considerable drawdown for the once high-flying New Zealand dollar (kiwi).
Against the benchmark US currency, the kiwi opened the three-month period by steadily pushing through records, eventually setting a new 25-year high of 0.8115. This peak was the culmination of more than a year of steady gains that travailed nearly 2,200 points for a staggering 37 percent rise. But, as the adage goes, what goes up must come down; and in the case of the markets, when something has been rising for too long, it often plummets with an exponentially greater velocity. Indeed, the kiwi did collapse under its own weight. In a mere three weeks from the July 24th high, NZDUSD bled 1,475 points – almost exactly two-thirds of its initial gains – before finally finding support.
Considering the market trends, the level of New Zealand’s interest rates and growth so far this year, it isn’t hard to appreciate the kiwi’s volatility. The Reserve Bank of New Zealand ratcheted the benchmark lending rate to the highest level in nine years on a string of three consecutive hikes aimed at curbing the booming consumer and housing sectors. However, considering the latest economic data there is little evidence that the most recent monetary tightening helped to tame the New Zealand economy. Looking out over the final quarter of the year and beyond, the persistence of consumer borrowing to purchase goods and houses will certainly command the attention of policy officials and the kiwi in turn. Another issue that will attract the attention of traders is the growing divide between politicians and policy makers. Often holding different objectives in mind, both sides have attempted to guide the currency lower in their own way.
[B]The Rise and Fall of Risk[/B]
The New Zealand currency’s bipolar price action this past quarter perfectly demonstrates the risks of complacency and leverage. Not long ago, volatility in the FX markets was at all time lows. Similar conditions were seen in equities, commodities, and bonds… With the last major, global financial market crisis fading into the misty recesses of traders’ minds, institutional, and retail investors once again grew ever more complacent in calculating exposure and risk. To compound the issue, quickly evaporating volatility forced market participants towards leverage and over-extended trades to find returns beyond the benchmark of already high flying equity indices. For many, specifically in the currency market and those looking to merely diversify their portfolios for reward purposes rather than risk dispersal, the steady income from the carry trade was a major draw. In the world of rate differentials, the New Zealand dollar was the optimal yielding currency for this popular strategy as it touted the second highest overnight lending rate among countries with the highest sovereign debt rating.
For a long time, the carry trade whiled its way untouched by worry. However, when the credit market itself was threatened the carry trade was quickly deemed a hazard and was frantically unwound. As losses mounted, herd mentality clicked in and the kiwi’s losses from the carry unwind were amplified. The ultimate drawdown was incredible; but the correction seemed to run its course relatively quickly. After only a few weeks, the sell off in the kiwi-linked carry trades (as well as equities, bond yields and most other instruments) came to an abrupt end. Over the remainder of the quarter, the New Zealand currency spent its time climbing back towards its record breaking highs. However, many of the initial uncertainties surrounding the flight to quality were unresolved. This will be a major consideration for the fourth quarter and beyond. Another international hedge fund implosion or - closer to the source - the public bankruptcy or cry for emergency from a New Zealand financial firm may spur another massive flight from risk; and the next one may not find its bottom so quickly. Another reason to believe the kiwi’s renewed vigor is tempting fate comes on the reasoning that the recent disturbance in the credit market has not been fully reflected in economic data. Should consumer spending or housing market activity cool in the months ahead, gains may be slowly eaten away and the carry trade permanently disabled.
[B]The Economic Factor (strong consumer/housing)[/B]
Amid all this discussion of risk appetite and the dangers of the carry trade appeal, there are still fundamentals underlying the practical demand for the New Zealand currency. Though lending rates are at all time highs and a high currency is clearly weighing on the vital export market, the island economy continues to perform well. According to the government’s most recent growth report, the economy grew 3.2 percent on a year-over-year basis, the fastest pace of expansion in two and a half years. Looking at the contributions made by the major expenditure groups, the usual suspects where carrying the entire economy on their shoulders. Consumer spending, accounting for nearly 60 percent of GDP, rose 1.0 percent through the period; this was considerable deceleration from the 2.4 percent pace from the opening quarter of the year, but strong nonetheless. A close companion of domestic consumption was residential building which surged 4.6 percent as strong employment and wage trends encouraged New Zealanders to take on ever more debt.
While these two sectors have certainly carried New Zealand to growth, they have also been covering for serious ailments in other corners of the economy. Though RBNZ Governor Alan Bollard’s efforts to muffle consumer spending have not borne fruit for his intended targets, policy changes have clearly curbed business and export activity. Business investment through the second quarter plunged 4.1 percent and the exchange rate helped boost imports by 2.5 percent versus a 0.5 percent increase in exports over the same period. Going forward, these inequalities will eventually reach a breaking point. Lending conditions and exchange rates will continue to stifle trade and business activity. It seems only a matter of time before the consumer succumbs to constant pressure.
RBNZ Holds the Keys
Considering the stubborn demand for credit among New Zealand consumers and their spendthrift habits, the eventual balancing of the economy and taming of the currency will likely follow the central bank’s policy stance. The Reserve Bank of New Zealand has long held a hawkish lean; but this passive inclination was turned to action in the first half of the year when Governor Bollard lifted the overnight cash rate at three consecutive policy meetings by a quarter point a piece, bringing the benchmark rate to a record high 8.25 percent. Since putting in the last 25 basis point stake, the central bank’s commentary has taken a decisively dovish tone. Where once certainties were used to promise a hawkish outlook, statements are now making reference to instability in global credit markets and an unjustifiably high currency. Through the remainder of the year, the impasse between high lending rates and persistent consumer spending trends is likely to sit firm. Even if there is evidence that rates are starting to work as intended, the central bank will likely hold off on a cut to ensure their eventual easing will not simply rekindle the same problems. What’s more, the policy authority will also have the incentive to hold off on any changes to lending rate until there is some level of certainty that the influence of credit reappraisals and volatility risk flows are no longer skewing economic data.
[B]Politics vs. Policy[/B]
The third quarter was full of abnormalities. With the central bank determined to rein in inflation and business activity and exchange rates the unintended, but very clearly effected, victim; it was inevitable that politics would come into play. Deeming the RBNZ Governor incapable or unwillingly to properly address the stifling exchange rate, Finance Minister played the bold rook by publicly musing that he may suspend the government’s agreement with Bollard that directs the Governor to target inflation. The jawboning would not put a substantial dent in the kiwi’s advance and have now laid credibility issues with the official. Though the central bank has consistently targeted inflation in its monetary policy, Bollard has certainly attempted to use alternatives to correct the New Zealand dollar apart from manipulating interest rates. He has repeatedly deemed the currency unjustifiably high, made a public event of direct intervention and changed FX management rules so that future interventions could be done more successfully. None of these side sweeps have worked. However, if the New Zealand dollar continues to creep back towards its record highs, Bollard would likely make further attempts along the same lines.
The kiwi dollar has not only achieved and lost multi-decade highs, it has also experienced some of the greatest volatility in the entire FX market. Clearly, the last few months have been closely based on the monetary policy and the lingering threat of still more oppressive rates ahead. Going into the final months of the year, the central bank has more reason to hold steady than before. Not only do they have to wait until its most recent string of rate hikes are factored into lagging economic data, there is now the possibility that the economy may bend under exogenous credit-market pressures. In the meantime, the RBNZ may try its hands at further intervention schemes such as attempting to talk the currency down, directly sell New Zealand dollars in the FX market or discuss possible changes to policy objectives with the government. What is for sure, whether it happen in 2007 or 2008, either the currency, rates or the economy will have to crack eventually.
[B]NZDUSD Technical Outlook[/B]
The NZDUSD is approaching resistance from the 7/31 high at .7731 and the 78.6% of .8108-.6639 at .7794. Regarding longer term implications, the NZDUSD and EURUSD patterns may be the exact same, but the NZDUSD is a little more mature. We have proposed that the EURUSD could be approaching a significant top near 1.4500. Kiwi may have already put in a significant top at .8108. The same A-B-C correction that we discussed with regards to the EURUSD could be unfolding in the NZDUSD. If .7463-.5927 was wave A, then wave B ended at .8108 (the 138.2% of A was at .8050…close to the actual end of proposed B). The down up sequence since .8108 may be waves 1 and 2 of C. If this is the case, then the NZDUSD decline should accelerate in the weeks ahead. .8108 is critical to the bearish bias. Even if the longer term bull trend remains intact, price is likely to drop below the 10/4 low at .7501 and possibly test the 9/25 low at.7304 before the next advance.
[B]Written by DailyFX Research Team[/B]