The 'reflation' trade and what it means for the Kiwi, interest rates, and shares

The Reserve Bank spent $570m on buying Government bonds last week

A shift in the Reserve Bank's survey of inflation expectations has boosted the New Zealand dollar, highlighting the currency's sensitivity to what is being called the "reflation" trade.

The survey's closely-watched two-year-ahead consumer price inflation measure firmed to 1.89 per cent, the highest in 12 months, up from 1.59 per cent in the fourth quarter of last year.

The data was enough to send the New Zealand dollar a quarter of a US cent higher.

The kiwi has been on a roll since late last year, thanks to data releases showing the economy was showing some resilience in the face of restricted activity due to Covid 19.

It last traded at US72.22c, up from US66.15c last October and US57c last March, when the pandemic sent shockwaves around the world.

ANZ senior strategist David Croy said the general vibe in the market was that the New Zealand economy was doing better than others.

"That thematic is still very much front of mind at the moment," he said.

"It's all lending itself to the idea that the Reserve Bank will be one of the first central banks to hike," he said.

Croy hastened to add that a rate hike was still a long way off.

Even so, the market has gone from expecting cuts in the official cash rate, currently at 0.25 per cent, to not expecting cuts at all.

"That's all due to the fact that the data keeps coming in better than expectations," Croy said.

"It (the kiwi's gain) is very much a domestic story, assisted in part by some weakness in the US dollar," he said.

Last week's favourable employment data shifted expectations as to where monetary policy is going.

Even though yields are still abnormally low, kiwi bonds are among one of the higher-yielding bonds across global markets.

Market-led movements in the Kiwi and in the long bond market have served to tighten monetary conditions at a time when the Reserve Bank is doing all it can to loosen them.

Last week, the bank spent $570m on buying Government bonds as part of its quantitative easing programme aimed at keeping funding costs low.

"We have seen a heck of a lot of tightening in monetary conditions with both long term interest rates going higher and the yield curve steepening and the New Zealand dollar going higher," Croy said.

"Our sense is that it is getting a bit too far ahead in the short term.

"Equally, it is difficult to see the market losing its enthusiasm for the kiwi and for high interest rate anytime soon, given the economic backdrop."

Jarrod Kerr, chief economist at Kiwibank, sees the kiwi heading towards US75c to US77c before the year's end.

While the Reserve Bank's inflation survey was not that surprising, it was enough to send 10-year swap yields up a further 5bps to 1.48 per cent - the highest in a year.

Kiwibank chief economist Jarrod Kerr. Picture supplied

Kerr said the foreign exchange market's reaction to the shift in inflation expectations was a reflection of what's been called the "reflation" trade.

"We have seen the interest rate market push higher and steeper, so longer-dated bonds are yielding higher than they were just a few months ago."

"Currency buyers and investors will see the kiwi and Aussie dollars as good places to put money in a pro-growth, pro-risk, reflation trade world," he said.

A firming kiwi and higher long bond yields do not help the Reserve Bank's cause as it continues to pull out all stops to keep monetary conditions loose.

The bank's next monetary policy statement, due on February 24, is largely expected to convey a "don't rock the boat" message.

"I think they will be reluctant to hike soon, but markets are already pricing in the risk of a rate hike by the end of next year.

"You have seen that reflected in interest rates and the currency."

"We are seen as being a standout performer and I think that the NZ Inc brands, and the Aussie brands, are much stronger after Covid after Covid, going forward."

Equities outlook

Concerns about inflation are spilling over into the equities market.

Mark Lister, head of private wealth research at Craigs Investment Partners, said the Reserve Bank's inflation survey was a continuation of a theme seen in other indicators.

"This is just another piece in the puzzle.

"Inflation is still really low by historical standards - 1.9 per cent (in the RBNZ survey) is still really low in the context of history, but it is definitely on the rise," he said.

Lister, noting recent gains in the New Zealand dollar and in interest rates, said rising inflation can hit the equity market on two fronts.

First is the likely impact on impact on interest rates and second is the effect it has on cost pressures for business.

"It is changing the way people think about which stocks and which sectors they want to be in."

To that end, the trend has been for investors to focus on the more cyclical stocks and the expense of the dividend-yield stocks.

Analysts said there was little to worry central banks, who would normally be looking at applying the brakes at the suggestion of emerging inflation pressures, just yet.

"I think that they are probably likely to tolerate higher inflation than they have done in the past," Lister said.

Harbour Asset Management said in a commentary that higher inflation and the prospect of a reduction in central bank support was becoming a concern.

"We think this risk is low given most economies have spare capacity that is keeping unemployment rates higher and inflation lower than central banks desire," it said.

"The ongoing threat of higher inflation and reduced monetary stimulus, however, is likely to lead to choppy trading conditions as investors manage the transition away from the low inflation and falling interest rate environment seen in recent years," Harbour said.