By Karen Pringle, ANZ Investment Bank
If currency strength is any guide, both Australia and New Zealand have clearly been the destinations of choice for investors since the start of 2003. Both the Aud and Nzd surged from the start of this year to three- and four-year highs, respectively. Against the US dollar, the Aud has risen more than 8% in 2003 and is up 30% from its April 2001 low. The Nzd is now up 44% from its October 2000 low.
While much of the rise in the Aud and Nzd last year reflected Usd weakness, this year both currencies have enjoyed more broad-based strength against Gbp, Jpy and European currencies, suggesting sentiment toward Australia and New Zealand has improved.
Investors appear to be paying even closer attention to the strong fundamentals in both economies because economic conditions have worsened elsewhere. Investors have been searching for sounder economies as safe havens and there are not too many to choose from right now. Economic fundamentals in Australia and New Zealand have remained very strong and the countries are therefore better placed to cope with any negative global consequences of a war in Iraq. Indeed Australia has grown faster than most OECD countries in the last few years.
In 2002, Australia’s economy grew by 3.8% and New Zealand’s by 4.25%. The only restraint on Australia’s growth was the sharp downturn in exports due to the drought and weak world growth: domestic demand surged by more than 6%. Drought effects will likely restrict economic growth to around 3% this year before bouncing back to around 4% again in 2004. Even though housing construction is set to turn down later this year, business investment is now rising strongly as Australian companies did not over-invest to the same extent as US companies in the late 1990s.
A strong housing market along with high levels of net immigration and a strong labour market is also driving New Zealand’s economy. New Zealand export returns have also been less affected by drought than Australia though the negative impact of the (relatively greater) Nzd appreciation is now being felt. As in Australia, growth in New Zealand should ease back toward 3% in 2003 whereas most of the rest of the world will continue to struggle to come close to this.
As a consequence of strong economic growth, short-term interest rates in Australia and New Zealand have been among the highest in the G20 at 4.75% and 5.75%, respectively, and differentials have widened in recent months after rate cuts in the US in November and in Europe and the UK this year. This has generated a renewed widening in bond spreads. Australian bonds in March were trading at around 160bps over comparable US treasury yields and New Zealand bonds were close to 230bps over. Indeed the 80-100 basis point pick up in New Zealand has been a key reason for the Nzd’s 16% out-performance against the Aud in this past year.
Shift in investor focus from equities to yields
Australian and New Zealand interest rates are the best on offer for AAA-rated countries and have been a magnet for capital into these countries over the past year or so. With the collapse in global share markets, cross border equity flows have shrunk significantly and investors are now chasing yield. High yielding currencies are therefore benefiting in a way that they weren’t before. This is in stark contrast to the latter part of the 1990s when Australian and New Zealand yield differentials were negative and cross border capital flows were dominated by equity flows seeking spectacular returns in ‘new economy’ stocks. Australian and New Zealand assets were relatively unattractive through that period.
The pick up in yield-based demand for Australian assets is evident in the 31% rise in offshore issuance of non-government bonds by Australian companies in 2002. This includes public issues and a growing participation in the private placement market (US Reg D market). Issues of Australian dollar bonds directly to Japanese retail investors (known as Aud Uridashi) were close to Aud4.2 billion in the December quarter and a monthly record of Aud4.3 billion in January.
The apparent slowing in domestic demand in Australia and official acknowledgement in New Zealand that the strong Nzd is hurting exports has led to speculation that both central banks could cut interest rates this year. However this is by no means assured.
In its February Monetary Policy Statement the Reserve Bank of Australia noted that financial conditions remain sufficiently expansionary, given low levels of interest rates and ready access to finance by households and business. Barring any adverse developments with the war in Iraq, it remains highly likely that the next move in Australia’s official interest rates is up, though it is still someway off.
In contrast, the Reserve Bank of New Zealand (RBNZ) has explicitly alluded to the possibility of lower New Zealand interest rates this year due to the potential deflationary impact of the higher Nzd in trade weighted terms. However, in its most recent March Monetary Policy Statement, it appeared less inclined toward cutting interest rates, despite the backdrop of heightened geopolitical uncertainty. The continued strength in domestic demand, coupled with a lack of evidence that inflation pressures are easing, suggests the RBNZ is now more likely to keep interest rates on hold in the near future if not for 2003 as a whole.
If there is any sign that the RBNZ is leaning again toward cutting interest rates (for example if the Nzd continues to strengthen sharply), this may be a trigger for a recovery in the Aud versus the Nzd after its significant underperformance last year. The expected convergence between Australian and New Zealand economic growth rates this year reinforces this prospect.
There is a confluence of very positive factors supporting renewed interest in Australian dollar and New Zealand dollar assets right now, but these factors are likely to be cyclical. Growth rates between Australia and New Zealand and the rest of the world will eventually converge as global recovery gathers momentum and there is no reason for Australian or New Zealand interest rates to remain significantly above US rates over time, aside from any liquidity premium. Indeed, we expect to see significant spread compression by the end of 2004 to coincide with a likely medium term top in both the Australian and New Zealand dollars. This is likely to be amplified once global stock markets begin to recover and investors switch their focus back to equities.
Karen Pringle is Senior Currency Strategist at ANZ Investment Bank in London.