Currencies | Oct 27 2011
– Risk aversion, interest rate differentials drive AUD/NZD exchange rate
– CBA expects current interest rate spread will narrow
– Bank forecasting a move to an AUD/NZD rate of 1.2700
By Chris Shaw
As Commonwealth Bank points out, the two drivers of the AUD/NZD exchange rate are risk aversion and Australian-New Zealand interest rate differentials. Any episodes of risk aversion usually drive the AUD/NZD rate lower, largely because the Australian dollar is the more heavily traded of the two currencies.
This correlation also tends to work in reverse, CBA FX economist Chris Tennent-Brown noting the Australian dollar has outperformed the New Zealand dollar over the past three weeks as risk appetites have improved.
In terms of interest rate differentials, the Australian-New Zealand two-year swap spread has widened by 40-basis points to 123-basis points since a mid-September low. In the same period, the AUD/NZD exchange rate has risen by around 6% from 1.2363 to a current level of around 1.3000.
The widening in the interest rate spread reflects a recent improvement in Australian economic data at the same time as New Zealand data has softened. As examples, Tennent-Brown points out unemployment in Australia has fallen to 5.2%, while Q2 GDP growth in New Zealand was a lower than expected 0.1%.
Inflation in Australia for the September quarter was also weaker than expected, the underlying rate rising by just 0.3% in quarter-on-quarter terms. For Tennent-Brown this suggests any Reserve Bank of Australia (RBA) decision on interest rates next month now depends heavily on whether or not the Europeans can deliver a credible rescue package for their financial system.
In New Zealand the expectation remains for rate hikes by the end of 2012, but in Tennent-Brown's view the recent slowing in economic data means the risk is rate hikes come later and any tightening cycle is more gradual than had previously been expected.
When market risk appetite improves Tennent-Brown notes the New Zealand market has greater scope for interest rate tightening. This is because at present rates in New Zealand are at “emergency levels” of 2.5% while the cash rate in Australia is slightly restrictive at 4.75%.
On a six-month time frame Tennent-Brown suggests if the level of risk aversion in the market eases further there is a risk rates rise in New Zealand but little chance of a similar move in Australia. But if risk aversion increases the RBA is the more likely of the two central banks to cut rates.
While either of the above scenarios could eventuate, in both cases the Australian-New Zealand interest rate spread is likely to narrow rather than widen. To reflect this view, Tennent-Brown expects the AUD/NZD exchange rate is likely to move to a rate of around 1.2700.
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