RBNZ Preview & Potential Scenarios for New Zealand Dollar

In less than 12 hours, the Reserve Bank of New Zealand is widely expected to raise interest rates for the first time in more than 3 years but with every single one of the 15 economists surveyed by Bloomberg calling for a 25bp hike, the actual increase may not be much of a surprise. Over the past few months, the RBNZ has made their intention to raise rates abundantly clear. In fact, the central bank even put some hard numbers as targets, saying they plan to bring interest rates from their current level of 2.5% to 4.75% by 2016. Investors have had plenty of time to discount the tightening and we know they are positioned for higher rates with the New Zealand dollar rising more than 7% against the U.S. and Australian dollars, 11% versus the JPY and 12% versus the CAD over the past 6 months. This begs the question of whether NZD will fall victim to buy the rumor sell the news liquidation after the RBNZ rate decision. To answer this question, we will outline at the various scenarios for the RBNZ rate decision and how they will impact NZD/USD. But first, lets take a look at how the economy has fared since the last monetary policy meeting in January.

How has New Zealand's Economy Changed Since January?

It has been almost 6 weeks since the last RBNZ rate decision and we have seen continued improvements in New Zealand's economy that will give the central bank the confidence to tighten. Although consumer confidence declined, there has been a significant pickup in consumer spending which will be positive for Q1 GDP growth. Service activity accelerated, the trade surplus increased and business confidence rose to a 20 year high. The jump in job advertisements at the start of the year suggests that the labor market is a key beneficiary of the optimistic outlook for businesses. Inflation is mixed with food prices rebounding strongly in January but commodity price growth slowed. The RBNZ has been keenly focused on the labor market but their efforts to cool growth has been met with uneven results. Some surveys have found prices rising further while others reported a small moderation. Either way, there has not been a significant slowdown despite more restrictive LVR terms. As a result, the RBNZ will need to take additional steps to normalize monetary policy and prevent a bubble from forming in the housing market. The outlook for New Zealand is promising because unlike Australia, the country is in the unique position of benefitting from China's focus on domestic growth. They bounced back strongly from fiscal consolidation, drought, a milk contamination scare and slower growth in Australia. Additional work on the city center, major projects such as a convention center and stadium along with the development of precincts dedicated to health, technology and culture will make 2014 a banner year for the economy. Residential and business investment along with growing demand for New Zealand's exports should also bring more jobs, higher wages, optimism and wealth.

3 Scenarios for RBNZ Rate Decision

As a rate hike by the Reserve Bank is a near certainty, how the New Zealand dollar will react to the monetary policy announcement will depend on how much forward guidance Governor Graeme Wheeler provides.

Scenario 1 - RBNZ Raise Rates 25bp, Wheeler Signals More Tightening to Come

The most bullish scenario for the New Zealand dollar would be a 25bp rate hike by the central bank followed by a strong commitment to continue tightening this year. Given the bright economic outlook, the central bank has every reason to start returning rates to normal levels and a 25bp rate hike this year won't be enough. The RBNZ is widely expected to raise interest rates by 75 to 100bp in 2014 and if their past actions can be a guide, they will want to give the market plenty of time to price in the moves. If the central bank indicates that today's rate hike is only the beginning of additional tightening, NZD/USD could make a run for its 2 year high of 0.8675.

Scenario 2 - RBNZ Raises Rates 25bp, Wheeler Complains about Strong Currency, Noncommittal on Future Tightening

Although the outlook for New Zealand is bright, Australia and China continue to slow and this could raise concerns for the central bank especially with the New Zealand dollar trading not far from record highs against the Australian dollar. Complaints about a strong currency would not be new. In fact after their last meeting, Wheeler said he did not see the high NZD rate as sustainable in the long run. However having failed at every attempt to intervene, we don't expect the RBNZ to do anything that would stand in the way of NZD strength. It certainly hasn't stopped them from talking about the need for rate increases. Nonetheless, by not committing to additional tightening, the central bank could trigger two-way volatility in their currency and ease some of the upside pressure. If the RBNZ simply raises rates and say no more, NZD/USD could drop below 84 cents on profit taking.

Scenario 3 - RBNZ Leaves Rates Unchanged at 2.5%

The worst-case scenario for the New Zealand dollar would be if the Reserve Bank left interest rates unchanged at 2.5%. This would be a big surprise for investors that should send NZD/USD sharply lower. Not only would the currency pair drop below 84 cents, but it could fall as low as 83 cents and continue to trend lower for the next few days. The chance that the RBNZ will keep monetary policy steady is extremely small but the strong currency naturally reduces inflationary pressures and their increase in the LVR ratio prevented a meaningful acceleration in house prices. With the Chinese economy slowing, the RBNZ could feel inclined to wait another month before normalizing monetary policy.