NZ: Markets under-pricing RBNZ easing risk - RBS

Research Team at RBS, notes that the short term rates markets are pricing in around 35bps of interest rate cuts by the Reserve Bank of New Zealand over the next year.

Key Quotes

“Easing expectations rebounded after the central bank kept its official cash rate unchanged at 2.00% on September 22 but continued to explicitly state more easing would be required despite New Zealand’s GDP growing at 3.6% in Q2’16, wholesale milk powder prices recovering from below US$1,900 per metric ton to almost $2,800 and NZ house price inflation remaining excessive.

The key challenge for the RBNZ remains the strength of the kiwi. In last month’s meeting statement it again warned: ‘weak global conditions and low interest rates relative to New Zealand are placing upward pressure on the New Zealand dollar exchange rate. The trade-weighted exchange rate is higher than assumed in the August Statement. Although this may partly reflect improved export prices, the high exchange rate continues to place pressure on the export and import-competing sectors and, together with low global inflation, is causing negative inflation in the tradables sector. A decline in the exchange rate is needed.’

In its August Monetary Policy Statement forecasts, the central bank projected the trade-weighted currency would fall from 76.0 to 73.0 over the next couple of years. But on Friday the kiwi’s trade-weighted index ended the week at 77.46.

The continuing strength of the currency is keeping inflation below target. In last month’s statement, the RBNZ observed: ‘headline inflation is being held below the target band by continuing negative tradables inflation. Annual CPI inflation is expected to weaken in the September quarter, reflecting lower fuel prices and cuts in ACC levies. Annual inflation is expected to rise from the December quarter, reflecting the policy stimulus to date, the strength of the domestic economy, reduced drag from tradables inflation, and rising non-tradables inflation. Although long-term inflation expectations are well-anchored at 2 percent, the sustained weakness in headline inflation risks further declines in inflation expectations.’

Ahead of the next RBNZ meeting on November 10, Q3’16 CPI inflation will be released on October 18 and Q4’16 CPI inflation expectations will be published on November 2.

The central bank is concerned that if inflation weakens as it currently forecasts from 0.4%y/y in Q2’16 to 0.2%y/y in Q3’16, two year inflation expectations in Q4’16 will fall again from its already near historic lows of 1.65%.

This risk suggests short-term rates markets should be pricing in more than 35bps of easing over the next year. In August’s Monetary Policy Statement, the RBNZ published an alternate scenario where the trade-weighted NZ dollar remained flat at 76.0 over the next couple of years. In that scenario, the central bank forecast it would need to cut its official cash rate below 1.00% in order to push inflation back into its 13% target band.”