It was a busy week for central banks around the world, with monetary policy meetings in the United States, New Zealand and Japan. This made for a very interesting end to the week for the forex markets as investors digested the deluge of information coming from policymakers. The lingering impact of these game-changing meetings, and possibility of fireworks in this week’s policy meeting in Europe as well, may continue to influence investor sentiment for some time to come as the market reassesses prior assumptions about the trajectory of monetary policy in these countries.
The Fed sends investors flocking to the dollar
In the United States, the Fed ended its third round of quantitative easing by tapering asset purchases by their final $15 billion and released a somewhat more hawkish statement than the market was expecting. The bank noted that labor market conditions have improved somewhat, with solid job gains and a lower unemployment rate. The underutilization of labor resources is also gradually diminishing according to the Fed.
The market immediately flocked to the U.S. dollar on the back of the Fed’s statement as U.S. treasury bond yields rose and stocks fell. Since then the U.S. dollar has gained even more ground against the struggling euro and yen, while the kiwi and aussie have been able to hold their ground on the back of robust investor sentiment and a slightly risk-on tone in the market, which has also helped to ease the impact of some dovish rhetoric from the Reserve Bank of New Zealand (RBNZ).
The question is, has the market overextended the dollar rally? The reaction to the Fed’s statement is somewhat more severe than one might expect, given that the actual course of monetary policy in the US remains very data dependent. While the Fed noted that the likelihood of inflation running persistently below 2% has diminished somewhat, we are still yet to see a meaningful pickup in consumer price growth. Some of this can be attributed to lower energy prices, but even once food and energy prices are taken out, inflation remains stagnant around 1.7% y/y. Core CPI was briefly able to hit 2.0% midway through the year, but it has since cooled. This means that the Fed, and the market for that matter, remain on data watch.
The Reserve Bank of New Zealand enters wait-and-see mode
Shortly after the policy meeting ended at the FOMC, the Reserve Bank of New Zealand concluded its own monetary policy meeting. The bank completely dropped its tightening bias which came as a mild surprise to the market; thus, NZD was sold off. The bank noted that a period of assessment remains appropriate before considering further policy adjustment, dropping a line from September’s statement that stated further tightening was expected and necessary to keep future average inflation near the 2% target midpoint and ensure that the economic expansion can be sustained.
The RBNZ does not want to risk stalling NZ’s economic recovery and, in any event, the bank’s prior reasons to tighten monetary policy has largely been removed with the cooling of the housing market (the RBNZ’s macro-prudential tools are akin to at least one 25bps rate hike from the perspective of the housing market) and softening commodity prices. At the same time, the RBNZ doesn’t want to risk strengthening the kiwi. A strong exchange rate is a big drag on growth in an export-based country such as New Zealand.
Some banks have now pushed out their expectations for tighter monetary policy in NZ. At this point it seems likely that the RBNZ will not raise the official cash rate until late Q3 2015, at the earliest. Some analysts are suggesting that the bank will not tighten policy until 2016, which may be overly dovish in our opinion. In saying that, a further deterioration of NZ’s inflation outlook may keep the RBNZ on the sidelines for all of next year. Net migration and strong construction growth should prevent the need for looser monetary policy.