We expect slowing Australian inflation, a balanced RBNZ statement and weakness in European activity indicators to depreciate AUD/NZD in coming weeks from the current two-month high. As such, we recommend buying a 1-month AUD/NZD put spread (strikes: 1.29 and 1.27); reference: forward: 1.2970, ATM volatility: 5.10%. The structure costs 30bp and has a maximum payout ratio of 4.2:1. Consistent with our view, Barclays’ Technical Strategy team favours selling AUD/NZD against 1.3065, which forms a key resistance level.
Slowing Australian inflation is likely to extend recent increases in market expectations of further RBA policy easing, capping the recent AUD/USD rally, in our view. We forecast underlying CPI inflation (defined as an equally weighted average of the RBA’s trimmed mean and weighted median measures) to decline to 2.0% y/y in Q2, from 2.2% in Q1. While our forecast is slightly above the consensus forecast of 1.9% y/y, it is consistent with the RBA’s forecast and at the lower bound of its 2-3% inflation target band. We think the realisation of our forecast would be sufficient to add to current RBA rate-cut expectations.
In contrast, we expect the upcoming Reserve Bank of New Zealand (RBNZ) Official Cash Rate Review (26 July) to support NZD/USD. We forecast an unchanged policy decision and a balanced statement inconsistent with the 20bp of rate cuts currently priced by year end. Economic growth has been stronger than the central bank’s expectations, with GDP growth of 1.1% in Q1 vs a RBNZ forecast of 0.4% q/q. CPI-inflation has been broadly in line. Balancing these views, the the RBNZ is likely to remain worried about European risks and reiterate its concerns about NZD strength.
We would therefore expect the 2-year New Zealand-Australia interest rate differential, which has widened 20bp since 12 July, to resume its narrowing trend and in turn put downward pressure on AUD/NZD (Figure 1). The underperformance of NZ commodity prices since late-April has, in our view, contributed to the breakdown in the historical relationship between relative yields and AUD/NZD. But we forecast the recent rebound in NZ commodity prices (Figure 2) to extend and provide greater support to the NZD (see FX Focus: NZD and commodity prices – milking it, 19 July 2012).
Furthermore, we expect weak euro area flash PMI readings (24 July) to be consistent with contracting output in manufacturing and services and to weigh on global risky assets. While our European economists forecast a small increase in the aggregate euro zone manufacturing PMI to 45.3 in July from 45.1 in June, this is well below the 50 threshold that demarcates contraction and expansion. In this environment, we expect the AUD to underperform the NZD given the former’s higher sensitivity to global equity movements (Figure 3).
An important risk to this trade is the 7 August RBA meeting, where we forecast the RBA to leave its policy rate unchanged at 3.50% vs. market pricing of around 11 bp of cuts. As a result, AUD/NZD may appreciate following an on-hold decision. That said, we would expect a rates rally to be concentrated in the very short end of the curve in this scenario, limiting an AUD/NZD rally, in our view. Another risk is that demand from exporters, reserve managers and SNB reserve diversification continues to support the AUD as we think it has done recently. In addition, the consensus forecast is that the NZ trade surplus fell to near zero in June, following several months of trade surpluses (data due tomorrow). However, this would be consistent with typical seasonal patterns and would not point to underlying weakness, based on our analysis.
Barclays Capital