NZD outlook : RBC

RBC Capital Markets notes:

1-3 Month Outlook - RBNZ easing

The RBNZ released a paper on inflation in late May, and we believe it was another small step toward a policy rate cut. The interpretation of the paper was that non-tradable inflation is not the prohibitive factor in terms of rate cuts that the RBNZ had been suggesting it was.

The market reaction was toward greater pricing for rate  uts from the Bank, and NZD/USD dipped to the lowest level since 2010. Our economists agree that a policy rate cut is in the cards, and that it could come as soon as this month. They also think that further deterioration in economic conditions will warrant a second rate cut in Q3.

In the wake of the paper on inflation drivers, there are now nearly two RBNZ cuts priced in the forward curve, which suggests only modest additional independent pressure on NZD in the case that these cuts are delivered. A June rate cut, however, would be sooner than the market is primed for, and would likely drive fresh cycle lows in NZD/USD in the very near-term.

In the coming months, NZD/USD should see more pressure from a rate spread perspective with the help of the Fed likely hiking later this year. Generally speaking, we continue to foresee the profile for NZD/USD as a trend lower, driven especially by policy trends (RBNZ cutting while the Fed enters a hiking cycle).

6-12 Month Outlook - Gradually lower

Over the longer horizon we view the profile for NZD/USD as gently weaker, and we think AUD/NZD should trend higher into 2016. Later this year we expect clearer evidence of a softer terms-of-trade that should dampen the activity profile as well as the outlook for employment, and should see cuts from the RBNZ.

Capital flows are one reason for support to NZD considering New Zealand is the highest yielding currency in G10 (and will remain that way even after the two cuts our economists are calling for), however, the country's small bond market makes it difficult for global investors to pour money into NZ. That means there is a limited scope for unhedged FI flows to support NZD (as they do for example with AUD). Moreover, further out, NZ yields should look less attractive as the interest rate gap between other G10 economies narrows.