The New Zealand dollar (NZD) has been under pressure since the start of the year, as investors bet on a series of interest rate cuts by the Reserve Bank of New Zealand (RBNZ) to curb inflation. However, recent developments suggest that the worst may be over for the kiwi, as higher dairy prices and a push-back of rate cuts by the RBNZ could boost its outlook.
Dairy is New Zealand’s biggest export, accounting for about 40% of its total trade value. The country is one of the world’s largest producers and exporters of milk and dairy products, such as cheese, butter, yogurt, and ice cream. The demand for dairy products is driven by domestic consumption, especially in China, which is New Zealand’s largest trading partner.
However, dairy prices have been volatile in recent months, due to various factors such as weather conditions, supply disruptions, trade tensions, and currency fluctuations. In August 2023, global dairy prices surged to their highest level since 2014, reaching $3.50 per kilogram of milk solids (KMS), up from $2.50 in July. This was mainly due to strong demand from China, which was recovering from a pandemic-induced slowdown and boosting its food imports.
How did this affect the NZD?
The rise in dairy prices had a positive impact on New Zealand’s terms of trade (ToT), which measures the ratio of export earnings to import costs. A higher ToT means that New Zealand can buy more imports with its exports, improving its balance of payments. According to ASB Bank Limited, New Zealand’s ToT rose by 9% year-on-year in September 2023, reaching $64 per barrel of oil equivalent (boe). This was partly due to higher dairy prices and partly due to lower oil prices.
However, a higher ToT also implies that New Zealand’s inflation rate will increase faster than expected. Inflation erodes the purchasing power of money and reduces its attractiveness as an investment asset. Therefore, if inflation exceeds the RBNZ’s target range of 1%-3%, it could prompt the central bank to raise interest rates sooner than anticipated.
What are interest rate expectations and why do they matter?
Interest rates are one of the main tools that central banks use to influence economic activity and inflation. By raising or lowering interest rates, central banks can affect borrowing costs for consumers and businesses, saving rates for households and firms, exchange rates for foreign investors and traders, and expectations for future economic conditions.
The RBNZ has kept its official cash rate (OCR) at 0.25% since March 2020, when it cut it by 100 basis points in response to the Covid-19 pandemic-induced recession. The OCR affects other interest rates in the economy through various channels such as bank lending rates, bond yields, mortgage rates, deposit rates, etc.
The market has been pricing an almost 80% chance that the RBNZ will ease policy again in May 2024, less than expectations at the start of January when it was around 90%. This reflects a more optimistic outlook for economic recovery amid easing lockdown restrictions and vaccination progress.
However, some economists expect that inflation will remain elevated above target until late 2024 or early 2025, requiring further rate hikes by both RBNZ and US Federal Reserve (Fed). The Fed has already signaled that it will start tapering its bond-buying program later this year and may raise interest rates three times in 2024.
What are some factors that could change these expectations?
There are several factors that could affect these expectations in either direction:
- Inflation data: The RBNZ will release its latest inflation report on Wednesday January 25th. The headline inflation measure is expected to slow down from 5.6% in December 2023 to 4.7% in January 2024, below but still above target range.
- Economic data: The RBNZ will also release its latest economic update on Wednesday January 25th. The key indicators include GDP growth (+0.8%), unemployment rate (+2%), consumer price index (+1%), business confidence index (+14%), etc.
- Trade data: The RBNZ will publish its latest trade balance report on Thursday January 26th. The trade balance measures whether a country earns more or less from exporting than importing goods and services.
- Dairy market: Global dairy prices may continue to rise or fall depending on supply-demand dynamics and other factors such as weather conditions.