While interest rates remain at rock-bottom levels among developed nations, one industrialized country has started to raise rates since March. Which one? Surprisingly, it’s New Zealand.

Last Friday, the Reserve Bank of New Zealand (RBNZ) raised its Official Cash Rate (OCR) by 25 basis points from 2.75% to 3.0%, making it the second tightening so far this year. And the market is already looking for another 25 bps rate hike in June.

The New Zealand economy has benefited in two areas: construction and agriculture. Low interest rates before the tightening and a damaging earthquake have helped spur a construction boom. Increased migration into the country also has boosted demand for housing, as well as demand for consumer goods. And, as neighboring Asian countries’ middle classes have grown, the demand for New Zealand’s dairy products have surged.

The NZD (known as the “Kiwi”) has responded to these higher interest rates, and is in fact the biggest gainer among major currencies since the beginning of this year. So when the RBNZ raised rates last week, did the NZD rally? Actually it was a non-event – if anything, the Kiwi drifted a touch lower. This price action is known by traders as “buy on rumor, sell on fact”. Basically it means that when expectations build up, the market responds. However, by the time the actual economic variable moves, there will be no action on the exchange rate, because the move was already widely discounted.

The NZD already hit a 2.5-year high earlier this month and even at today’s level, is overvalued from the real interest rate point of view, as well as from the purchasing power parity point of view (a calculation of adequate price levels in comparison to other countries).

My View: In the short run, it would appear that there is still some upside momentum for the NZD as this is still the beginning of the tightening cycle and the market is still feeling out the RBNZ’s moves. However, the market has already priced in another 200 bps of short-term interest rate hikes in New Zealand by the end of this year, putting their OCR at 5.0% by then. Since its CPI is only at 1.5% now, unless inflation really gets out of control there, much of the upside move for the Kiwi may already be discounted for the longer term.

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