What is happening down under

Over the summer months the most significant movers of the G10 currencies were the Norwegian krone (NOK) and the New Zealand dollar (NZD). The krone weakened significantly against the US dollar, while the NZD was propelled upwards following half a year of consistent declines.

Further examination of the moves throws up a common theme. Assuming that NOK weakness has been exaggerated by the unwinding of a once popular macro trade in the past few months (long NOK positions are held in anticipation that oil prices will keep on rising), the same factor may be at least partly responsible for the recent strength of the NZD.

The NZD fell about 15% against the US dollar earlier this year as the economy showed signs of slowing. This reduced expectations of further monetary tightening and focused attention on the problem of funding New Zealand's massive current account deficit.

In particular, the reliance on Uridashi bonds issued to Japanese investors came into focus. With Japan recovering, and very large redemptions of these bonds due over the next two years, the risk of continued rapid NZD depreciation seemed very high.

During the summer, the NZD stabilised and, more recently, comments from the Royal Bank of New Zealand Governor have raised the prospect of tightening again, as inflation has not eased back as rapidly as the RBNZ expected. Furthermore, with strong export growth helping to offset the effects of weakening, the NZD began to recover sharply.

However, the scale of the move in the NZD does not seem to be warranted by the move in interest rate expectations. This can be seen by looking at the relationship between the NZD and its neighbour, the Australian Dollar (AUD).

Looking at the relationship between weekly changes in the two-year interest rate swap spread versus weekly changes in the cross rate, it is found that the relationship is positive. That is, moves in relative interest rate expectations in favour of the AUD are associated with a rising AUD-NZD cross rate, and vice versa.

Since the beginning of August, the spread has moved in the NZD's favour by 30 basis points, while the cross has fallen by 9%. The historical relationship suggests that only a 1.2% move would be warranted by this scale of spread move. Given the statistical significance of the relationship between the spread and movements in the currencies, the risks are now skewed firmly towards an upward correction in the AUD-NZD cross rate.

Indeed, on current form, any such move on a longer term basis may have to come from the market realising that the NZD has been taken too far, with the outlook for Australian economic performance far from spectacular. There remains a risk of a rate hike this month, however, with a still stretched labour market and indications of a revival of housing construction acting as potential sources of inflationary pressure.

Also, the trade balance is making impressive strides with the deficit narrowing to only AUD208 million in August. However, with GDP growth in the second quarter of 2006 at a five-year low of 1.9% year-on-year, the chances of substantial AUD appreciation in the long term appear relatively slim.

The anticipated US slowdown and the prospect of softening commodity prices are likely to weigh heavily on the Australian economy and inflation expectations throughout 2007. In such a context, further Royal Bank of Australia tightening beyond the November meeting cannot be realistically contemplated.

One of the most significant G10 currency moves over the past two months has been NZD strength. However, the move has been considerably more than can be explained by changes in interest rate expectations, and seems more consistent with position liquidation in a once popular macro trade.

Assuming this liquidation is more or less complete, the risks are for some unwinding of this move in the near future. With the potential for the Royal Bank of Australia to take some of the market by surprise and raise interest rates at this month's meeting, there is the opportunity for AUD-NZD to undergo something of a recovery.

This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.