Central Bank Divergence

A central bank divergence can be a great way to pair up a weak currency against a stringer one. One of the tricky areas in trading FX recently has been that central banks have been cutting rates in a coordinated way. There has been a race to cut interest rates across all the banks. So, with all the central banks following the same path this has made a central bank divergence trade quite rare lately. However, the latest moves by the RBNZ has changed that. This is due to the RBNZ’s willingness to embrace native interest rates.

On Wednesday the RBNZ Monetary Policy Committee agreed to significantly expand the Large Scale Asset Purchase (LSAP) programme potential to $60 billion. However, this was pretty much expected. It was the potential for negative interest rates which caused the kiwi to sell off. RBNZ’s deputy Governor Geoff Bascand confirmed that the RBNZ would like to be ready for negative rates by the end of the year. When a central bank reduces interest rates this causes its currency to fall.

Given that New Zealand has already broken out of COIVD19 induced lockdown measures the dovish tilt was surprising. So, we have to remember that there is possibility of a domestic improvement which negates the need for negative rates going forward.

Central Bank Divergence: RBA vs RBNZ

The Reserve Bank of Australia,  by contrast,  is less inclined to negative rates and does not favour them. So, we can therefore expect to see a divergence between the AUD and the NZD. Due to this situation the yield spread between the Australian and New Zealand 10 year bond will be set to widen. See the chart here from a Bloomberg piece on this yesterday showing the yield spread difference between the tow 10 year bonds (white line). Notice how the AUDNZD pair follows the spread between the two bonds:

Therefore, look for pullbacks on the AUDNZD pair and expect buyers to enter around the 1.0700 handle as long as this central bank divergence remains.