As was almost unanimously expected by commentators, the Reserve Bank of New Zealand (RBNZ) this morning increased our official cash rate (OCR) from 2.5% to 2.75%.
If we ignore the rate hikes of June/July 2010, which were reversed relatively soon after, this marks the beginning of the first cycle of interest rate rises in NZ since 2007.
What are the implications of this for markets?
In terms of the interest rate market, while the 0.25% OCR increase was no surprise, the RBNZ also delivered this morning a set of very strong forecasts for growth and interest rates. This has led investors to now be anticipating, roughly speaking, one more interest rate hike than was the case previously. As a result, looking out until the end of 2015, the market is currently expecting further increases in the OCR of around 2%, to take the cash rate to around 4.75%.
In currency markets, the New Zealand dollar has once again pushed higher today, to a new record high on a trade-weighted basis.
This is despite the RBNZ reiterating today that they believe that the current high exchange rate is not sustainable in the long run.
With the currency at such high levels, it would not be surprising to see a modest drop in the short term. However, looking further ahead, we expect that the $NZ is likely to remain relatively strong. This is due to the solid performance of the NZ economy, the fact that our interest rates are very high relative to many other countries where rates are close to zero, and the fact that we are one of the few countries in the world at present where rates are increasing.
For local share market investors, higher interest rates will over time have a cooling impact on demand for shares. However, we think this process will occur only slowly – over several quarters. There are several reasons for this, including that most local companies have hedged their borrowing costs, so that a higher OCR does not immediately lead to lower earnings.
Looking historically, the NZ share market has continued to make gains on average through prior rate hike cycles. An average gain of 4.8% has been made for the NZX50 gross index in the first six months of the RBNZ’s previous 5 tightening cycles since the OCR framework was introduced in 1999.
To conclude, despite today’s rate increase we think the NZ share market can continue to perform well over 2014 – after all the Reserve Bank is tightening due to the strength in the local economy, and that strength is ultimately supportive for shares too.