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Opinion: End of tightening cycle may be a turning point for investors

By Simon Louisson of NZPA

Friday 9th December 2005

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This week may be a turning point for investors.

Reserve Bank governor Alan Bollard hiked interest rates again yesterday as expected but his accompanying commentary, while still stern, was less strident than previous comments he made in October.

Further rate hikes could not be ruled out and there was no room for cuts in the foreseeable future, he said. Hardly a soft line.

Still, he was equivocal about the future, acknowledging risks of a "hard landing" (recession), that would require interest rate cuts.

"Whether further tightening is needed will depend on the extent to which housing demand pressures show signs of moderating over the months ahead," Bollard said.

Reading the "tea leaves" of Dr Bollard's coded centralbankspeak, economists and financial markets interpreted his more "dovish" (softer) tone, as signalling the end of the tightening cycle in place since January last year. Over that time the Official Cash Rate has been ratcheted up from 5% to 7.25% - by far the highest in the developed world.

"The overall message from the statement is that this is the last rate rise - they couldn't say it explicitly because of the uncertainties and risks that always go along with monetary policy," said ANZ National Bank chief economist John McDermott.

"They have definitely toned the statement down from September, indicating that this is the last one," he added.

Bollard's problem is that much of the real economy is already in recession but inflation is still running over 3% as a hangover from the previous few years when economic growth was 4 and 5%. And the housing market boom, which has fuelled the consumer spend-up and the consequent inflation, is stubbornly refusing to bust. So he doesn't want to signal he is easing off the brake, even though he is.

Some of the reaction to yesterday's announcement was just what Bollard wanted - the dollar, which this week hit 20-year post-float highs on the trade-weighted index and against the Australian dollar, came off sharply as speculators pre-empted the easing phase.

Ninety day bank bill yields, from which bank's fund mortgages, fell 9 points, partly due to the softer tone of the statement and partly in relief he didn't hike rates half a percentage point as some had feared.

The sharemarket had turned down sharply ahead of the statement - losing 2% in the first two days of the week. It firmed a tad yesterday in relief, but then resumed its sharp "correction" today as the implications of Bollard's analysis of the economy sank in. The top 50 share index is now off 8% from its October 4 peak.

"People are worried about the economic outlook and the earnings outlook and there was widespread selling," said UBS broker Richard Leggat.

High interest rates are never good for equities.

Goldman Sachs JB Were broker Murray Rutherford said he, and many investors, fear Dr Bollard's medicine to cure high inflation is worse than the disease.

How the housing market reacts is the $64 million question.

Bollard forecast house prices would cool rather than crash over the next 12 months as more people refinance fixed loans at rates north of 9%. However, the bank picked prices declining in real terms over the next few years.

The bank hasn't had a great track record forecasting house prices. It expected a "correction" to have already occurred. Instead, prices rose another 15% in the year to November.

As ever, Bollard is stuck on the horns of a dilemma. By not raising the OCR for fear of turning a soft landing hard, he could allow inflation pressures to escalate to "uncomfortable levels".

On the other hand, the bank knows policy adjustments take 12-18 months to have effect and that's the time horizon the bank should be focusing on.

"If we misread the lags, there is a risk that policy tightening undertaken now will start to bite just at the point when domestic demand is already cooling," he said.

The bank provided two alternative scenarios to its central one of a gradual decline in domestic spending and the New Zealand dollar.

The first saw momentum in the housing market continuing into 2006 and 2007, further fuelling demand. When that boom is eventually exhausted, the correction will be sharper and the fall in house prices will be heavier.

Under Scenario 2, there is "a sharper correction of economic imbalances". This hard landing scenario assumes the heavier fall in the exchange rate and domestic spending comes sooner. Inflation pressure would relent as domestic spending retreats, "allowing for a lower interest rate profile".

The bank's central forecast predicts reasonable economic growth of 3% in the year to March 2006 declining to 2% in 2007 and 1.5% the following year.

Westpac chief economist Brendan O'Donovan said he struggled to reconcile that forecast with the bank's prediction that private consumption - the lion's share of the economy - would fall to zero over 2006 and 2007.

McDermott said ANZ National's growth profile is similar to the RB's, only the timing of the downturn is significantly different.

"We think it happens a bit sooner."

McDermott believes the bank is schizophrenic in its messages about the impending downturn.

"They are afraid it won't happen and yet they seem to acknowledge that it will happen, and when it does, it will be a bit harder than we really want it."

If the downturn/recession comes sooner, rather than later, then almost certainly the relative attraction of the kiwi dollar will diminish as the RB begins a rate cutting cycle. Foreign investors will shun New Zealand assets where the outlook for interest rates, the currency and the economy is down. That suggests the long running rise of the kiwi dollar and the sharemarket is likely to reverse.

"The risks are growing that the kiwi has seen its peak," said BNZ chief foreign exchange dealer Mike Symonds. However, like many, because Bollard's message is so mixed, he covered himself saying: "It's a little bit premature to suggest with confidence that's the case."

"We are going to need to see some concrete evidence that the New Zealand economy is slowing sharply - as some economists are forewarning - before we see the kiwi dollar undermined significantly."

Whether a currency and sharemarket downturn is accompanied by a housing downturn will be interesting. Rentals have remained static for a couple of years and these normally lead house prices, according to Bob Hargreaves, property studies professor at Massey University.

House prices have risen twice as fast as rentals, so that could be indicative that the worm has turned for house prices.

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