Reserve Bank of New Zealand Drops Rate 50bps, But Why? And So What?

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Includes: AUNZ, ENZL
by: Econ Grapher

So the Reserve Bank of New Zealand (RBNZ) did what most economists were expecting and cut the official cash rate by 50 basis points, back to 2.50%, as an emergency response to the earthquake. Was it the right thing to do? Probably. Will it result in a harder inflation challenge later on? Possibly. From a confidence perspective, the earthquake did make a dent, but even before the earthquake things weren't exactly booming. So on balance the move will likely be positive for the New Zealand economy through 2011.

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In its statement, the RBNZ referred explicitly to the negative impact on business and consumer confidence, the immediate impact on economic activity in Christchurch and nationally, and pointed to the future rebuilding effort. Jumping to the usual last-paragraph-analysis, the bank said this:

"Future monetary policy adjustments will be guided by emerging economic data. We expect that the current monetary policy accommodation will need to be removed once the rebuilding phase materialises. This will take some time. For now we have acted pre-emptively in reducing the OCR to lessen the economic impact of the earthquake and guard against the risk of this impact becoming especially severe."

Which is effectively acknowledging that the rate cut is a temporary move. It also acknowledges the impact the rebuilding will have i.e. a short term boost to economic growth, as well as a pressure on inflation. Speaking of which, the most recent data saw the New Zealand economy expanding 1.5% year on year in Q3, with inflation at 4.0% in Q4; it is likely that Q4 GDP data will be nothing special.

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So what are the implications of the decision on New Zealand investments and financial markets?

Following the announcement the 90-day bill rate dropped off to about 2.66% from 2.81%, while the NZD/USD rate fell from around 0.740 to 0.736, with the market largely having already priced the move in. Looking forward, inflation and growth are likely to be positively impacted by the move, thus the yield curve will likely steepen somewhat, and the NZD may be supported further.

Looking to the NZ ETF space, the New Zealand dollar currency ETF (BNZ) could be used to play on an eventual strengthening of the New Zealand economy, and future interest rate hikes. Already the NZD is being strongly supported by soft commodity prices. However calling a fall in the New Zealand dollar has been a long running past-time, but to be fair on a PPP basis the New Zealand dollar is quite over valued against the USD.

Over to the New Zealand equity ETF (NYSEARCA:ENZL), there could be a long argument there on the basis of a short-to-medium term pick up in economic activity (not to mention the dividends - NZ companies tend to pay relatively high dividends). The rest of the economy will be boosted by the interest rate cut, and one-off gains from New Zealand hosting the Rugby World Cup may help build momentum. Then there's the post-earthquake rebuilding phase. So the balance of risks are probably weighted slightly toward the upside for New Zealand equities over the medium term, but then, there's probably other markets that will do better.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.