Kiwi dollar poised to fly as US investors go for safe-haven gap

By Neville Bennett

Friday 12th July 2002

The record of the Reserve Bank has often been criticised. The National Business Review discovered and campaigned against the bank's assumption the country's sustainable rate of growth was a mere 3%.

Similarly, the NBR broke the story of how in 1995-96 the New Zealand dollar was driven to unsustainable heights by the issue of eurokiwi and samurai bonds issued in kiwi dollars.

It is time again to warn that the bank's hawkish attitudes have created a large spread or differential in international interest rates that will tempt international investors to chase New Zealand assets. This will again drive up the New Zealand dollar, possibly to damaging levels.

New Zealand has enjoyed good growth this year but the bank has twice raised interest rates. The latest hike surprised the market, as it seemed an act of defiance toward Finance Minister Michael Cullen. It also seemed unnecessary as the kiwi had strengthened more than the bank had expected: enough to put downward pressure on prices.

High interest rates have already spurred a strong appreciation of the kiwi this year. Other favourable factors include strong growth and a shakedown of the US dollar. However, the bank's eagerness raises the prospect of "overshoot," in the National Bank's view.

It is predicting a rate of 53USc. The kiwi has risen 10% in a few weeks and is likely to gain between a quarter and a third this year from its low of 38USc. Business requires a stable and steady outlook. It is most unhappy when monetary policy becomes volatile and unstable.

Of course, it could be argued the bank's role is limited. After all, it might be argued the kiwi has risen mostly because the US dollar has fallen. This merely conceals the dysfunction in the foreign exchange market. It ignores a huge change in the Australia-New Zealand exchange rate.

On the face of it, an observer might expect stability in the Australia-New Zealand crossrate. Both countries are commodity exporters. Both are at the top of their business cycles, driven by consumer confidence, booming housing and good export prices. A degree of equilibrium might be expected. However, the kiwi has moved from 79Ac to 88Ac, a huge change.

The kiwi reached 88Ac in 1995. That provides a clue to what is happening now. In 1995-96 the Reserve Bank raised rates repeatedly, largely to dampen the Auckland housing market. Auckland was subdued but Invercargill was devastated by an adverse exchange rate of 70USc.

The bank did not appreciate that a high gap in interest rate yields attracts foreign fixed interest rate investors. The proverbial Belgian dentist chases the highest secure yields. To cater for the dentist (or Japanese housewife) the market issues eurokiwi, samurai or simple junk bonds in New Zealand currency. The demand for billion of kiwi dollars drives up its price.

That process is occurring now. The differential between 90-day notes issued by the New Zealand and US Treasuries is a colossal 4.2%. This is immensely attractive to foreign buyers. The difference on two-year stock is 325 basic points.

Newsletters are pointing out this gap to their clients. It is perhaps the most profitable arbitrage in the world in good government paper. New Zealand is a safe haven, too, in a world more conscious of terrorism. There will be a rash of bonds issued here and the kiwi will fly.

Foreign appetites for kiwi assets are enhanced by the perception that Dr Cullen has vetoed more rate increases. Bondholders are allergic to rate increases as these depreciate the capital value of their notes. The much-respected BCA Research explicitly recommends its clients "avoid Australian bonds as the RBA [Reserve Bank of Australia] will eventually be forced to hike rates."

Obviously, the Reserve Bank of New Zealand has been pro-active in raising interest rates. It and the Swedish reserve bank led the world in tightening rates in the current cycle. Japan has a steadfast policy of zero interest rates, the EU has not tightened and the US has loosened since 2000.

Yet, the Reserve Bank has been hawkish. Its purview seems doggedly domestic. The time has come for the bank to consider the international implications of its actions.

WIDENING GAP - NZ v US bond spreads

	Two-year	Five-year	Ten-year

NZ	6.04%	6.45%	6.70%
US	2.82%	4.02%	4.82%
Spread	322pts	243pts	189pts

Source: CBS, RBNZ (July 8)

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