NZD: Yield drives further gains – RBC CM

Adam Cole, Research Analyst at RBC Capital Markets, suggests that looking at relative to domestic rate expectations, NZD continues to defy gravity.

Key Quotes

“The compression of forward rate spreads against the US, which began two years previously, has continued unabated taking the 2yr spread to a 15 year low. Yet NZD has risen steadily this year against USD and also AUD and CAD. We think this reflects a shift in the determinants of FX returns – interest dynamics matter less, outright yield matters more.

In other words, markets are being driven by carry. Although it may appear counterintuitive that carry is a viable G10 FX strategy in a world where yields are so low, on a relative basis, cross currency G10 carry trades now look as attractive as they back in 2006.

Relative to what OIS forwards imply (a little more than one cut by mid-2017), our forecasts still suggest more room for RBNZ rate cuts. Our economists expect a cut next month and another early in 2017. Recent experience suggests, however, that any short-term NZD weakness will be bought into by investors hungry for yield as NZD would remain the highest-yielding currency in G10. We expect NZD/USD to end 2016 at 0.78, a level last seen in early 2015.

6-12 Month Outlook – Strength will eventually bite

In real terms, NZ’s trade balance is showing some improvement driven by services. But exports of non-commodity goods continue to decline. NZD is well above its long-term average real effective exchange rate but with trade accounting for a decreasing share of FX turnover, a currency can spend much longer in ‘overvalued’ territory – in some cases  as long as several decades. We still expect to see NZD/USD grind lower as NZ/US policy diverges more meaningfully in late 2017 and 2018, but that is becoming a much longer-term story. Our end 2017 forecast is 0.76, unchanged from last month.”