The New Zealand dollar has had a wild and eventful ride this year, soaring to new heights of 81 cents against the US dollar, only for its wings to be clipped as global credit fears sent investors rushing out the narrow exit door.  Ultimately, the performance of a currency is tied to the fortunes of the underlying economy.  But in the near-term, many factors can influence the direction of the currency and some take greater prominence over others at different times.

The ride up in the New Zealand dollar over the first half of this year reflected a global environment that was benign and marked by low volatility.  Liquidity was also abundant, and the combination of these encouraged increased risk taking by investors and speculators.  Yield differentials were the key driver of currency movements, as investors increasingly piled on to the "carry trade".  Successive interest rate increases by the RBNZ this year increased the yield attractiveness of the New Zealand dollar further.  In addition, the rise of a new breed of currency speculators – the Japanese margin traders or sometimes referred to as "Mrs Watanabe" – became an increasing influence on foreign exchange markets.  Their hunger for the high yields being offered by New Zealand propelled the New Zealand dollar to successive new highs.

But the global environment changed in August, when large losses incurred on US subprime mortgages by hedge funds led to nervousness about the extent that such losses would spread.  Investors who previously were risk seeking suddenly became risk averse.  Positions in risky assets were liquidated and flight to safety flows flooded into US government bonds.  Equities, commodities and "carry trade" currencies including the New Zealand dollar were sold off aggressively as investors and speculators took a "sell first ask questions later" approach.  The turmoil in financial markets threatened to turn into a full blown credit crunch when major commercial banks in Europe and US started hoarding cash and refused to on-lend to one another, forcing the US Federal Reserve and the European Central Bank to inject liquidity into their banking systems.

Of late, the turmoil in financial markets appears to have settled down.  Though the aggressive easing in monetary policy by the US Federal Reserve represents an acknowledgement of the seriousness of the threat posed by faltering credit markets, the move has seen confidence and stability return to financial markets.  In fact, risk appetites look to be back on the table, as investors are once again dipping their toes into riskier assets such as commodities, equities and currencies.  Whether this will last remains to be seen.  It is unlikely that we will go back to the low volatility environment prior to the August turmoil.  The current environment remains fluid and volatile, and sentiment remains fragile.

Nonetheless, the carry trade is being put back on as investors are out chasing yield once again.  In addition, the prevailing theme in the currency market at present is one of US dollar weakness.  It seems the US dollar can do no right, with the greenback pushed to record lows against the euro and also on the US dollar index.  US dollar weakness translates through into New Zealand dollar strength by default.  This has seen the New Zealand dollar rebound just as strongly past 77 cents in recent weeks as it had fallen during the August market turmoil.  Another factor providing support in the near-term to the New Zealand dollar is Australian dollar strength.  Despite recent strength, our medium-term view remains bearish on the New Zealand dollar.  There are finally signs that the New Zealand housing market has turned, and consumer spending is starting to moderate.  The turn in the global credit cycle will have an effect on the New Zealand economy, which is heavily reliant on offshore funding. All these suggest that we have seen the peak in the New Zealand dollar for this current cycle.  While strong commodity prices and still relatively high interest rates provide some support for the New Zealand dollar, they will ultimately take a back seat to slowing economic growth.  We will likely see further volatility in the currency in the months to come, with small grinds up to be followed by larger moves lower.  As we have already witnessed twice this year, the New Zealand dollar can move sharply lower in a short space of time.

For more information please contact:

Khoon Goh, Senior Economist

ANZ National Bank

khoon.goh@anznational.co.nz