Will the RBNZ Rate Decision Trigger Carry Trade Unwind?

RBNZ Rate Decision (21:00GMT)
NZ Trade Balance (MAR) (22:45GMT)
Expected: 7.50%
Expected: NZ$000M
Previous: 7.50%
Previous: -NZ$127M

How Will The Markets React?
Though New Zealand government bonds have been fluctuating unabashedly on speculation surrounding the Reserve Bank of New Zealand’s rate decision, the nation’s equities market and currency have slowly worked themselves into tight ranges ahead of the sizable event risk. More than just a policy decision for a small-island economy, this meeting could affect global risk appetite - especially through the favored carry trade strategy among currency traders. The New Zealand dollar has become the bellwether for the carry trade with the highest overnight lending rate among the G10. What’s more, the heavily-funded carry trade has in recent months drawn close ties to risky trades in nearly every market. While the passive collection of carry is not inherently dangerous in itself, the complacency of buying an already overbought currency (the New Zealand dollar) against a considerably depressed currency (the Japanese yen for example) is quite dangerous. For confirmation of the correlation between the carry strategy and more risky trades one only has to look back to the end of February/early March. During that period, a massive correction in global equity markets led to a drop in the kiwi dollar. For NZDJPY, the drop would measure 800 points in the span of a few days. Now, the markets are waiting to see if the upcoming RBNZ rate decision will rouse the same level of cross market volatility seen in late February. Just ahead of the meeting, economists were expecting policy makers to leave the benchmark lending rate unchanged at the record-high 7.50 percent. On the other hand, this isn’t the feeling in the market. Interest rate futures show traders are fully pricing a rate hike. This seems to be a well-supported outlook, since RBNZ Governor Bollard’s key components for policy making (domestic spending and housing) are still charging ahead. Conversely, with such heavy, one sided expectations, the disappointment of a pass could lead to a considerable relief retracement.
Bonds - 10-Year New Zealand Government Bond Yields
Yields on the benchmark New Zealand government bond have moved wildly over the past few weeks as speculation of a second RBNZ rate hike have run rampant. Looking back to when the central bank raised rates 25 basis points to a record 7.50 on March 8th, traders hardly reacted since analysts, economists and traders had expected as much. However, conditions are different this time around. Data has not fully confirmed a hawkish outlook. February retail sales hit a three-year high in February and home sales rates rose to a seven-year high; but the annual measure of the first quarter inflation gauge actually eased to 2.5 percent. Creating even more tension, economists are countering traders’ projections of a hike as they believe another 25 bps could further exacerbate economic imbalances.

The New Zealand dollar remains at a standstill, wedged between a supporting trendline and resistance at the 25 year highs near .7500. However, the Reserve Bank of New Zealand’s interest rate decision could be the event to shake Kiwi out of its tight range. While the central bank is anticipated to leave rates steady, the simultaneous release of the monetary policy statement could have a decidedly hawkish slant considering the persistent price pressures in the economy - possibly hinting at the potential for rate hikes later in the year, subsequently bringing about a Kiwi bid. The New Zealand trade balance figure adds to event risk as well, as exports are anticipated to gain - despite a strong New Zealand dollar. Meanwhile, imports are also forecasted to pick up, potentially signaling to the central bank that consumption is sturdy enough to withstand another round of policy tightening.
On the other hand, the RBNZ could take a decidedly more dovish route if they foresee a cooling of inflation pressures in coming months, coinciding with the soft CPI release out of Australia yesterday. The markets may simply be waiting for a sign that the carry traded is exhausted - albeit temporarily. Thus, should we see a Kiwi-bearish statement from the RBNZ, along with a disappointing trade balance, NZDUSD could break down through trendline support and the .7400 level towards .7200. Furthermore, the sentiment could feed into Aussie trade as well, unleashing the liquidation of leveraged bets and a move towards risk-aversion.

Equities - NZX 50 FF Gross Index
With the Reserve Bank of New Zealand’s interest rate decision on the horizon, the benchmark NZX-50 index dropped 0.9 percent to 4,163.11, led by medical equipment manufacturer Fisher & Paykel Healthcare. Shares of Fisher & Paykel resumed their slide, dropping 2.2 percent to NZ$3.54 after the company lowered its fiscal 2007 profit outlook last month on the back of the rapid appreciation of the New Zealand dollar. Other exporters suffered a similar fate, with fishery Sanford down 2.2 percent to NZ$4.55, technology focused Rakon 0.8 percent lower to NZ$4.81, and carpet maker Cavalier out 3 percent to NZ$3.20.
New Zealand equities could continue their declines when the markets reopen this week, as the Reserve Bank of New Zealand’s rate decision could spark some major volatility. While the central bank is anticipated to leave rates steady, the simultaneous release of the monetary policy statement could have a decidedly hawkish slant considering the persistent price pressures in the economy - possibly hinting at the potential for rate hikes later in the year. Furthermore, the trade balance figure creates major event risk as well. Though the trade account is forecasted to show a balance between exports and imports, the jump in the New Zealand dollar over the course of March could have led to an unexpected decline in foreign demand for goods from the country. Overall, the odds are not in favor of New Zealand equities, and a surprisingly dovish tone by the RBNZ or a strong improvement in the trade balance may be necessary to send the NZX-50 Index rallying once again.