How Much Will New Zealand Cut Interest Rates?

Everyone is focused on the Federal Reserve’s interest rate decision at 2:15pm ET this afternoon, but I actually have my eye on the Reserve Bank of New Zealand’s rate decision. With interest rates already at a target range of 0-0.25 percent, the Fed’s ability to surprise the market is virtually nil. The RBNZ on the other hand has a number of options at their disposal.

New Zealand interest rates are currently at 3 percent and the market forecasts a 50bp rate cut this afternoon (5pm ET) that would bring rates down to a record low of 2.50 percent. However a half point cut is not a done deal as there are reasons for the RBNZ to over and under deliver:

Business confidence has been improving while retail sales actually increased in the month of February. Yet the recent rally in the New Zealand dollar will lead to tighter monetary conditions for the region as a whole. Prime Minister John Key also openly admitted earlier this month that the country cannot afford additional fiscal spending because it could provoke a credit ratings downgrade. Instead, they are planning to cut government spending. One of few ways to offset lower fiscal stimulus is through monetary stimulus and therefore the RBNZ may be compelled to over deliver and possibly talk of further easing to come.

With interest rates at relatively high levels, the RBNZ is not ready to embark on Quantitative Easing. Currency intervention is also unlikely because that has always been a losing battle for the central bank.

The New Zealand dollar is up more than 3 percent today which suggests that forex traders expect a kiwi positive decision from the RBNZ. Either way, the central bank interest rate decision will play a large role in determining where the currency is headed next.

source: eSignal

source: eSignal

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New Zealand: Recession Over?

The Reserve Bank of New Zealand cut interest rates by 150bp this afternoon to 5 percent. This is the largest interest rate cut for the central bank and brings their total easing since July to 325bp.

Although the degree of the rate cut was not that big of a surprise, the  comments from RBNZ Governor Bollard were very interesting. Even though he said that further rate cuts may be warranted, he also indicated that recession in New Zealand may already be over,.  This is the reason why the New Zealand dollar rallied after the large rate cut.

The economy is still expected to contract until June but at least for New Zealand a bottom is near. We can only hope the same for the US.  The 30 percent decline in the currency year to date is one of the primary reasons why the New Zealand economy will be able to recover quickly.

The combination of a weak currency and another 100bp of expected rate cuts will help to support the economy.

Think about what a strong dollar does to the US economy.

Will the BoE and ECB Under or Overdeliver?

In less than 24 hours, we have interest rate decisions from 3 countries:

1. New Zealand
2. United Kingdom
3. Eurozone

With the global easing cycle in full swing, rate cuts are expected all around. New Zealand and the UK have been two of the most aggressive countries when it comes to cutting interest rates.  At their last meetings, the RBNZ delivered a 100bp rate cut while the UK delivered a 150bp cut.  In contrast, the ECB has been the least aggressive next to the BoJ who don’t have much room to cut to begin with. The RBNZ and BoE’s commitment to lowering interest rates is one of the main reasons why the Euro sold off against the New Zealand dollar and British pound today.  The BoE’s heavier hand has driven EUR/GBP back towards its record highs.

UK Service, manufacturing and construction PMI reports are all at record lows, reflecting the deep slowdown in the UK economy. There is a risk of a 125bp rate cut if the Bank of England continues to be proactive.  Since their next interest rate cut will certainly not be their last, they may decide to do more now than later.

Although weak economic data may have the European Central Bank considering a 75bp instead of 50bp rate cut, they have a track record of underdelivering when it comes to monetary easing.  A 75bp rate cut would be largest in the ECB’s history.

Here’s a look at what is expected for the upcoming meetings.

Reserve Bank of New Zealand – 150bp Cut Expected on 12/03

The Reserve Bank of New Zealand cut interest rates rates by a full percentage point in October, citing “ongoing financial market turmoil and a deteriorating outlook for global growth. In a statement published in an article released by the RBNZ, the bank notes that “global developments have proven extremely disruptive and it will likely be some time before financial market conditions normalize. The Bank will continue to adopt measures as needed to maintain the stability of our financial system as far as possible in these difficult times.”Once again we see some very dovish statements made explicitly from central banks. The recession embattled country has plenty of ammunition as rates are at the very high level of 6.50%. While zero percent interest rates may not be a possibility, it is possible that we will be surprised by some extremely aggressive cuts. The market currently expects the RBNZ to cut as much as 1.5 percentage points in December and eventually take interest rates down to 5 percent. It is also important to note that rates have not fallen below 4.50% in the last ten years.

Bank of England – 100bp Cut Expected on 12/04

The Bank of England has been the most aggressive and proactive of the G-10 central banks in their attempts to ease monetary policy. The most recent cut of 150bp was a huge surprise to all traders and represents the largest single meeting cut to occur for any of the major central banks during the financial crisis. However what was even more shocking was the fact that the minutes from the most recent monetary policy meeting in early November suggested that they considered an even larger interest rate cut. Going into the December monetary policy decision, the market expects the BoE to ease by another 100bp. With the economy in a recession according to UK officials, interest rates could fall as low as 1% if the crisis continues well into the New Year. The BoE’s ability to cut by such a sizable amount was also reflected in the fact that inflation, once the primary concern, has eased considerably in the last few months. In addition to monetary stimulus, the UK government has been at the forefront of bank bailouts and fiscal stimulus.

European Central Bank – 50bp Cut Expected on 12/04
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The Race to Zero Interest Rates

With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?

We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.

We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.

What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Here’s where the major central banks stand and what is expected for the next meeting:

Federal Reserve – 50bp Cut Expected on 12/16

On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.

European Central Bank – 50bp Cut Expected on 12/04
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How Much More Can the Dollar Rise and Will It Hurt Exporters?

Dollar bulls continue to take the markets by the horns, driving the British pound to a 5 year low and the Euro below 1.28. Deleveraging and risk aversion have been the primary catalysts for the strength in the low yielders (US dollar and Japanese Yen) but currency bets gone wrong, repatriation and the fears of weak growth in Europe have also fueled the rally.

Although earnings from US banks has been everyone’s main focus, European banks will also be reporting earnings soon and they could face some serious losses as well, especially the ones that have recently received assistance from their local governments. Liquidity problems are usually synonymous with major balance sheet problems for banks. In the corporate sector, Citic Pacific and Latin American companies will not be the only ones to suffer losses from currency bets as they try their hands in the FX markets. The outlook for the European economies is very grim and when combined with risk aversion in the financial markets, it translates into severe weakness for the Euro and the British pound against the US dollar.

The Dollar Could Rise Another 5 Percent

After injecting a massive amount of liquidity into the financial markets, central banks are finally seeing their desired reaction as LIBOR rates fall and lending becomes more fluid. In the long run, this should help to stabilize the financial markets and restore confidence, but in the short term, there could be further dollar strength. Since the Purchasing Power Parity levels for the EUR/USD and GBP/USD are approximately 1.15 and 1.56 respectively, the dollar could rally another 5 percent before the dust settles. Furthermore, the Fed has made another announcement in an attempt to stabilize the financial markets. They changed the interest rate that they are paying on excess reserves from 75bp below the Fed funds rate to 35bp. The announcement itself was not a big surprise, but the timing was. They have could have made this announcement next week when they cut interest rates, but their decision to do so now rather than later suggests that they may be preparing for a smaller rate cut next week. Unless the Federal Reserve wants to take interest rates to zero percent, each quarter point rate cut may need to be rationed from here on forward. The Bank of Canada certainly felt this way when they cut interest rates by only 25bp on Tuesday.

How Much Will Dollar Strength Hurt Exporters?

On a trade weighted basis, the US dollar has appreciated more than 18 percent since July. The typical notion is that dollar weakness helps US exporters while dollar strength hurts them but globalization has actually changed this dynamic with some exporters now benefiting from dollar strength. The key is in their expenses because if they manufacture abroad, dollar strength reduces their foreign expenses. A perfect example is Caterpillar Inc, the world’s largest manufacturer of construction and mining equipment. In the third quarter, they actually recorded an exchange rate gain because the strength of the dollar reduced their net liability position in Europe. Google on the other hand took a big hit from dollar strength. Although the company does not export anything, more than 50 percent of their revenues come from outside of the United States. As the dollar appreciates, it reduces the value of their foreign earnings. The same is true for Yahoo.

Therefore just because a US company is export driven does not mean that the dollar’s recent strength will be a drag on earnings. At the same time, a multinational service oriented firm is just as vulnerable to currency fluctuations as an export firm.
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