New Zealand‘s economy could be on the brink of recession. We target the NZD/USD at 0.70 in three months and at 0.65 before the end of the year.
| The New Zealand dollar has been falling sharply against the world’s most heavily traded currencies on speculation that the Reserve Bank of New Zealand would have to cut interest rates faster than traders had previously expected. Indeed, the rapid deterioration of the New Zealand economy prompted many investors to exit the so called carry trades despite New Zealand’s high level of interest rate. Yet, the current wave of risk aversion in the world’s financial markets which forced many investors to cut holdings of higher yielding currencies has not been the only factor putting downward pressure on the value of the New Zealand dollar. In fact, several economic indicators suggest the New Zealand’s economy could face bigger problems in the second half of 2008 as record high interest rates slow consumer spending and business investment. But is New Zealand’s economy heading into a recession? | ||||||||||
New Zealand‘s Economy is on the Brink of Recession
Over the past decade, a substantial search for yield propelled by spare amounts of liquidity drove up exchange rates for many small open economies such as New Zealand. This environment helped to fuel a sharp increase in domestic asset prices but also made New Zealand’s economy more vulnerable to external shocks. Now, with the world economy slowing down, New Zealand is facing its biggest challenge in more than 20 years. They have been hit by a slowdown in global growth and by rising high energy and food prices. In fact, according to Statistics New Zealand, the economy shrank 0.3 percent in the first quarter of 2008, largely due to the impact of higher energy prices, a drought on agriculture and a slowdown in construction and household spending. The widening of the current account deficit was mainly due to crude oil imports which surged 25 percent from a year earlier. However, energy prices are not the only cause to blame for New Zealand’s poor economic performance. Indeed, real household spending which has been the main driver of economic growth over the past few years, is now projected to contract over the next quarter. Despite the fiscal stimulus announced by the New Zealand’s government, record high mortgage rates and food price increases are reducing the amount of disposable income households have for discretionary spending. Moreover, several years of strong economic growth have contributed to an annual inflation running above 4 percent which fashioned higher wages but also made New Zealand’s products less competitive abroad. Currently, New Zealand runs a current account deficit equal to 7.8 per cent of gross domestic product and the trade deficit for the year to May was 4.8 billion dollars, up from 4.6 billion dollars in the year to April. Since foreign goods must be purchased using foreign currency such outflows may lead to a depreciation of New Zealand dollar unless countered by similar capital inflows. In addition, New Zealanders are very pessimistic regarding the future of their economy. According to a survey conducted by Westpac to 1,556 consumers on their personal finances, consumer confidence fell to the lowest level since the 1991, adding to evidence that the economy is already in recession.
New Zealand dollar could depreciate further in the Second Half of 2008
The Reserve Bank of New Zealand conducts its monetary policy by setting the Official Cash Rate. Yet, the bank’s primary objective is to maintain price stability by keeping inflation between 1 and 3 percent, based on a contract negotiated between the Minister of Finance and the Reserve Bank. The complexity here is that the current economic environment of weak economic activity and high inflation is producing a difficult puzzle for the RBNZ to solve. In fact, significant increases in oil and food prices are occurring at the same time as the economic activity is weakening. Looking ahead, the combination of rising headline inflation, reflecting higher commodity prices, with weak economic growth, could prove to be very damaging for New Zealand’s economy. The RBNZ projects modest GDP growth over 2008 but we are expecting the June quarter to show a further contraction, satisfying the definition of a technical recession as two consecutive quarters of negative growth. In our opinion, although upside risks for inflation remain evident, they also appear to have diminished somewhat and the RBNZ is likely to focus its monetary policy on the downside risks to growth. According to interest rate swaps for deposits denominated in New Zealand dollars, traders have already priced in a series of rate cuts by the RBNZ in 2008. While the 3 month swap rate stands at 8.33 percent, the 2 year rate is being offered at 7.30 percent and the 10 year yield at a much lower 7.07 percent. Below is graph that plots a spread between the 3 Months and the 2 year interest rate.
Generally, lower interest rates make holding the New Zealand dollar less attractive to foreign investors and the lower level of demand for assets denominated in New Zealand dollars could place downward pressure on the value of the kiwi. On the other hand, a reduction in interest rates should help to stimulate New Zealand’s economy by making borrowing more affordable and investment more attractive. Then, easy money could stimulate spending and create the necessary conditions for a sharp economic rebound. Yet, despite the benefits of lower interest rates in the long term, they are unlikely to help the New Zealand dollar in the short-term. As a result, we expect the currency to continue to depreciate against both the U.S. dollar and the Australian dollar. We target the NZD/USD at 0.70 in three months and at 0.65 before the end of the year. In addition, we expect the kiwi to lose some ground against the aussie and we project the AUD/NZD to be trading at 1.30 by September and at 1.35 by the end of 2008.
Written by Antonio Sousa, Chief Strategist
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