The Reserve Bank of New Zealand cut its official cash rate, the interest it charges commercial banks for overnight loans, by 25 basis points. In a classic case of the exception proving the rule, the New Zealand dollar (NZD) strengthened against the USD instead of weakening as might have been expected.
Reserve Bank Governor Graeme Wheeler implied the NZD was much closer to value at the new rate, which means that further rates cuts may not be necessary.
The general rule of economics is that when a central bank cuts rates, the currency weakens as the return on investment diminishes. The last cut in interest rates by the New Zealand Reserve Bank resulted in the NZD (kiwi) losing almost 1% of its value against the USD.
Speculators tend to borrow money in countries with lower interest rates and then invest that money in a country with higher rates in a practice known as the ‘carry trade’. This type of speculative action has the effect of lowering the value of the currency of the country that has decreased its rates.
The kiwi (NZDUSD, -0.3783), which is an extremely liquid market, makes it an attractive destination for carry trades as speculators are allowed to enter and exit positions in the currency very easily. The interest rate in New Zealand, even after the rate cut, is high compared to the prevailing rates in Europe, the U.S. and Japan.
A number of speculators were expecting a 50 basis point drop in the rate and took aggressive bets against the currency that it would depreciate in value in a practice known as a short.
By lowering the rate by 25 basis points instead of the expected 50, the effect on the currency was almost that of increasing the rate, triggering what is termed a short squeeze. Shorting an asset means that speculators borrow the asset and then immediately sell it in the belief that they will be able to buy it back at a lower price before having to make the repayment.
When the opposite happens, as in the case of NZD, brokers very often force the speculative traders to repay the money immediately. They then face the situation that they have to buy back at the higher price.
Win Thin, the global head of emerging markets strategy at Brown Brother Harriman, said that the so-called short covering had in reality started earlier in the week. Thin also pointed out that because the kiwi’s rapid decline had caused the currency to become overstretched, the kiwi has risen 2% against the USD since Monday. The currency still remains 15% down year-to-date.