NZD Bulls at Risk of Re-Pricing Says Morgan Stanley

NZD Bulls at Risk of Re-Pricing Says Morgan Stanley

 Published: January 14th, 2022

Analysts at Morgan Stanley believe the Reserve Bank of New Zealand (RBNZ) is likely to disappoint on interest rates, despite the high expectations held by investors.

The bank’s Forex Analysis unit says the New Zealand dollar (NZD) is looking potentially overpriced and at risk of a correction as RBNZ rate hike expectations move to the downside. The key determinant will be the impact of the Omicron COVID-19 variant on central banker opinion.

In a note to investors, Morgan said central banks around the world are having to consider changing economic and trade dynamics thanks to the pandemic’s most recent surge. As case loads rise, demand could be affected by self-isolation and curbs on economic activity and travel.

Markets continue to price in hawkish action by the RNBZ, Morgan says, regardless of higher infection rates. ‘If the bank delivers a surprise on the dovish side, there's more potential for NZD weakness than if they deliver as anticipated on the policy front.’

The note comes at a crucial juncture, given that four of the world's biggest central banks might be poised to raise rates again in the first quarter. For the Reserve Bank of New Zealand, it would mark the third rate hike in six months.

‘The RBNZ and BoC (Bank of Canada) are among the G10’s most hawkish central banks,’ says the note. ‘To varying degrees, investors have already priced in the likelihood of central bank action. That suggests an elevated volatility risk for volatility but also a dovish bias which might not be borne out.’

This year, one of the market drivers in currency markets will be the pace of central bank policy normalisation and how quickly monetary policymakers raise interest rates and scale down pandemic-driven quantitative easing.

When it happens, it will almost certainly raise the yield on government bonds, with a concurrent rise in the cost of consumer and business borrowing.

Countries that take the lead will be expected to see their currencies advance over the laggards. But the disappointment when investor expectations aren’t realised could create currency weakness. If the New Zealand central bank's timeline for normalisation is pushed back, for example, Morgan analysts say NZD could see declines.

Gauging expectations

Figures from OIS markets, which tracks investor consensus around interest rate moves, has the RBNZ leading the G10 pack, with a cumulative expectation of 150-plus basis points in rate hikes this year.

The Bank of Canada is expected to deliver 140 basis points of hikes in 2022. That’s in stark contrast to the 85 basis points anticipated from the US Fed, 103 from the Bank of England, or the 105 expected from the Reserve Bank of Australia.

‘The clearest example of the dynamic is still found in NZD, where a rate hike is priced in for the first quarter, likely in February,’ says Morgan Stanley. ‘That’s one reason why we’re holding onto our bearish stance on NZD. There is probably no G10 currency with more asymmetric downside risk from near-term central bank policy moves.’

Morgan analysts are also maintaining a 'long' position on the AUD/NZD exchange rate in anticipation of RBNZ disappointment.

‘The amount of tightening already underway raises the risk of an overtightening error in 2022. As infections from the COVID-19 Omicron variant rise, border and business restrictions may stay in place longer. The economic challenges arising from this could impact New Zealand's externally-focused sectors.’

A quarter is a long time in forex

In late September, FX Strategists at NatWest Markets in London said they were maintaining a long position on NZD, fuelling more upside for the kiwi after months of outperformance.

The bank’s currency analysts pegged the New Zealand dollar for more gains after signals that the RBNZ would raise interest rates, giving a boost to the economy despite the arrival of new Covid restrictions.

Markets began to act on expectations for a rise of around 25 basis points as the kiwi economy proved resilient, suggesting that the central bank’s record-low interest rates were overly cautious.

‘While we believe there is significant evidence that global-economic trends support a more aggressive stance on interest rates, there is still a COVID risk premium to factor consider,’ NatWest write in a market analysis.

NatWest did note that the possibility of a rate rise this year would diminish if the country’s COVID-19 situation deteriorated. New Zealand has been held up throughout the pandemic as an example of success, with decisive and robust action to keep the spread of the virus under close control. At the time, governments around the world were dealing with the virulent delta variant of coronavirus.

Kiwi amongst the G10 leaders in 2021

The month before, in August 2021, NZD was the G10’s second-best performer, with only the Norwegian Krone offering occasional competition.

On 12th August 2021, USD/NZD reached the seventh day of successive declines, while NZD/GBP rose from an August low of 0.6802 back to levels above 0.7046.

August’s price dipped again when the RBNZ made the surprise decision to ignore market expectations and let interest rates stay at low levels. Bank policymakers said the recent imposition of new COVID-19 lockdowns was behind the decision. No change to the country’s economic fundamentals had been identified.

When expectations grow for higher interest rates, exchange rates for the New Zealand dollar tend to respond quickly.

At the time, the RBNZ’s policy committee seemed keen to sustain market expectations for higher rates. The bank’s assistant governor, Christian Hawkesby, had told the financial press that the central bank was fully committed to higher rates. Forex traders responded by opening new positions or holding NZD.

Hawkesby said in an interview with Bloomberg that the bank ‘could have easily supported a hike,' but given that the government was set to announce new lockdowns the same week, the bank believed the timing for a rate change was wrong.

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