Written by DailyFX

NZD/USD Outlook

The New Zealand dollar came under significant pressure in the first half of 2006. The currency pair sold off 15 percent over the past six months from a high of 0.70 in mid January to a low of 0.5925 in late June. Over the past few years, the New Zealand dollar and its currency has been one of the darlings of the foreign exchange market because of the country's high interest rates and appreciating value. However it is these two same things that have led to the demise of the currency in 2006. A strong kiwi has crippled the export sector while the high interest rate has curtailed domestic spending. In the face of rising global inflationary pressures the Reserve Bank of New Zealand has not been able to lower interest rates. Governor Bollard has instead chosen to talk down the currency by saying that depreciation in the exchange rate was warranted, which interestingly enough may end up saving New Zealand's economy. Exchange rate fluctuations take time to pass through, so we may not see the impact until the fourth quarter of 2006, but the longer the kiwi remains weak, the more stimulus it injects into New Zealand's economy. Once the economy shows clear signs of improving, the outlook for the kiwi may be more promising.

Agricultural Prices Fall, Exports Take a Big Hit

Given New Zealand's dependence on international trade, sky-high exchange rates put severe strains on export-driven national industries while fostering a boom in imports. Coupled with very high domestic borrowing costs, the strong currency pushed the small economy into a brief recession in the final quarter of 2005. The 15 percent decline in the New Zealand Dollar against the US dollar has changed the face of the national trade deficit by exacerbating inflexible energy and commodities spending. Unfortunately for New Zealand their primary export are agricultural commodities and not gold like its neighbor Australia. Agricultural commodities have actually fallen 10 percent in value since the beginning of the year and at the same time, oil prices have remained extremely high. Given record-high oil prices, expenditures on increased energy consumption decimated the overall trade balance. This may be a surprise given that New Zealand has traditionally produced a large share of its own oil, but a quick look at current consumptions statistics show that the country now imports over 80% of its annual usage. Surging import prices have subsequently offset the gain in export volume, which reached an all-time monthly high of NZ$3.649 billion in May. This dichotomy of higher imports and lower exports simply reflects the medium-term effects of a depreciated national currency.

Foreigners Repatriate Investment Income

At the same time, high interest rates earned on New Zealand debt created a net outflow of NZ$11.18 billion on investment income - forcing the yearly current account deficit to a record high of NZ$14.54 billion in the first quarter of 2006. This massive deficit raised questions of whether the relatively small economy could sustain such large interest rate payments on debts. Many investors subsequently fear that New Zealand could lose its AA+ S&P sovereignty rating if such deficits are to continue. In this worst-case scenario, international investors would likely flee to the safety of high-yielding US debt - causing large sell-offs in the NZ dollar. Though a large-scale exodus has yet to materialize, we can already see the gradual outflow of investment dollars from Kiwi fixed income markets. With the spread on New Zealand 10-year Government Bonds and US 10-year Treasuries at a mere 80 basis points, many investors have already shifted assets to the world's largest economy. A move out of Kiwi dollar-denominated assets has added downward pressure to the overall exchange rate, but the hope is that smaller foreign holdings on national government debt could actually prove a net-positive for the NZD. Indeed, such a trend has the potential to stabilize the current account deficit and restore confidence in the small economy's ability to repay its foreign obligations.

Interest Rates Expected to Remain Unchanged for the Remainder of the Year

With so much to contend with, the Reserve Bank of New Zealand has no choice but to keep interest rates unchanged. If the inflation picture was more favorable, they would probably opt to lower interest rates to boost growth, but at this point, they will probably not choose to do so. Even though inflation rose to a five year high in the second quarter, interest rates at 7.25 percent should be sufficient to eliminate the risk of heightened inflationary pressures while allowing for sustainable domestic growth. The RBNZ might issue a more hawkish statement following their end of July meeting, but with economic growth at its current pace and the risk of a potential ratings downgrade, they will probably be extremely cautious with bringing their interest rate even higher. Admittedly, quarterly inflation was the highest in 16 years while annualized inflation was the highest in 5, but the government has already anticipated the possibility of a rise. They feel that if inflation is above their 3 percent band for only one or two years, that it is short term rather than medium term and is thus not a breach of policy target agreements or a cause for immediate concern. However, should they choose to raise interest rates, we could see only a small rise in the New Zealand dollar as the threat of a hit to growth caps gains.

A slowdown in national industry pushed the New Zealand economy to a slight recession in the final quarter of 2005 - presumably limiting the risk of rampant inflation. Despite this, a positive outlook on overall economic recovery and predictions of moderate inflation leaves the Reserve Bank of New Zealand at a privileged position compared to its worldwide counterparts. Current interest rates of 7.25% will likely eliminate the risk of heightened inflationary pressures while allowing for sustainable domestic growth. Monetary policy is subsequently to remain unchanged through the second half of the year. This will perhaps allow interest rate hikes from the US Fed or the Bank of Japan to push the NZD lower in the coming months, but this is consistent with RBNZ officials' expressed desires. Bank president Allan Bollard has said that imbalances in world interest rates caused an overvaluation of the New Zealand dollar, but a rebalance in international monetary policy will allow greater equilibrium and growth for the small island nation. He likewise expects that this will contribute positively to the future of the economy, providing little impetus to tamper with the current agenda.

Conclusion

The New Zealand dollar will probably stay muted through the second half of the year as worldwide investors pare their NZD-denominated carry trades, but at the same time, the lower currency should contribute to economic recovery and an eventual return to long-term growth levels. In the long run, a lower currency will boost national export industries and tourism - a welcome change for producers who have seen their profit margins deteriorate because of high input prices and lower international demand. On that same note, increased competitiveness of NZ production through a depreciated national currency should boost exports and drive domestic demand higher. The greatest risk to this emerging trend remains to be any further gains in world commodity prices. Due to the small nation's dependence on foreign raw-materials, it is particularly vulnerable to heightened energy and production costs. Absent this risk, however, we believe that the New Zealand economy should continue on its return to growth through the third and final quarter of the year. Given the lag on widely followed economic indicators, this will be unlikely to sway currency markets in the medium term, but the New Zealand dollar could stage a recovery in 2007 on the next wave in the natural business cycle.

Technical Outlook

Kiwi plummeted briefly below the .6000 figure and made a double bottom at the same level as the May 2004 low at .5909 in the process. Bullish divergence accompanied the .5927 low on the weekly and price has since bounced above .6200. Further, Kiwi currently trades at a resisting trendline from the December 2005 high at .7198. A break higher would be bullish and potentially test fibo resistance levels from the .7463-.5927 March 2005 ? June 2006 bear wave at .6513 (38.2%), and .6695 (50%). Trading to these levels could be choppy since the potential move up is viewed as a correction of the downtrend from .7462. Weakness beyond the .5927 low however would negate the above mentioned hypothesis and possibly lead to a test of the confluence of the 50% fibo of the .3895-.7462 October 2000 to March 2005 uptrend / July, August, and September 2003 lows at .5632/79. The Fibonacci relationships within the waves of the .7462-.5927 downtrend increase the likelihood that .5927 was an important low. The downtrend is a 5 wave downtrend and the length of waves 3 through 5 is nearly identical to 161.8% of the length of wave 1.

DailyFX