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The Reserve Bank of New Zealand decided to cut rates by an additional 50bp today to a record low of 2.5 percent, resulting in an instantaneous sell-off in the New Zealand dollar. Perhaps more telling than the rate cut itself was the RBNZ’s statements regarding the health of their economy. RBNZ Governor Alan Bollard announced that there is a real threat to inflation, as “weaker global growth and an unwarranted tightening in financial conditions” may sink the economy into a deflationary spiral. As a whole, Bollard’s comments were more dovish than many had anticipated. He cautioned that the New Zealand economy remains weak with Business and consumer sentiment suffering and employment reduced. This combination of factors may in fact warrant further rate cuts, which nonetheless will remain at low levels into late 2010. Continued monetary easing may be required to pick up the slack where fiscal stimulus left off since the government is planning to cut spending. Bollard even sets the 2.5% target rate as a ceiling for the next year in monetary action. The RBNZ Governor stills holds onto a few shreds of optimism. He is confident that financial markets are showing signs of stabilization and that progress has been made in tending to the banking sector. Even though the New Zealand economy may eventually recover like Bollard mentions, he also said that “it won’t fell like that on the street.” Don’t expect the RBNZ to follow in the footsteps of the Federal Reserve, Bank of England and Bank of Japan by taking interest rates to zero. Bollard made it clear that New Zealand is not a zero interest rate economy..

How Will the Kiwi Trade in Response to the Decision?

The New Zealand dollar completely reversed direction after the announcement of the interest rate decision. After being up by more than 150 pips, the kiwi only manages to hold on to a gain of 40. As an intermediate technical analysis, kiwi dollar faces support at the 0.5486 low placed on April 20th. After that, we have the 50% retracement of early March lows to April highs at 0.5438. In case markets should decide to change their minds and reverse direction, resistance is placed at the 23.6% retracement at 0.5725, followed by the April 6th high of about 0.5982.

The Federal Reserve has grown less pessimistic, driving the U.S. dollar higher against all of the major currencies. As we expected, the U.S. central bank did not expand their asset purchase program and left their target interest rate unchanged at 0 – 0.25 percent. It is extremely important that the Fed went out of their way to say that the pace of economic contraction is slowing, consumer spending is stabilizing and that “policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

The Fed did not need to make any changes to their statement at this time because only recently have we seen evidence of improvements in economic data. They could have waited another month to be certain that the improvements can be sustained but the fact that they went out of their way to say that they are less pessimistic indicates that they want to downplay the results of the stress tests on banks. There is no question that we are still a long way from a recovery but the downside risks are easing. The labor market remains the Achilles Heel of the U.S. economy and only when companies stop firing will the economy be able to engage in a sustainable recovery.

The FOMC statement is in line with the comments made by Paul Volcker this afternoon. As the current Chair of the President’s Economic Recovery Advisory Board, Volcker has Obama’s ear. He said that the economy is leveling off and more stimulus is not needed. He also believes that none of the major banks will fail and that inflation will not be a threat until two or three years from now. However that does not mean that the risk of weaker economic data is behind us, because even Volcker admitted that there could be more dissatisfactory data. What he is telling us is that we near the end game of monetary and fiscal stimulus and the Fed seems to agree. The Obama Administration has an extended an extravagant amount of stimulus and it will take time for the trillion dollar fix to bear fruit. All we can do now is wait for the U.S. economy to get back on track but in the meantime, the less pessimistic outlook of government officials should translate an overall improvement in risk appetite.

U.S. equities hit 2 month highs on an intraday basis, encouraging currency traders to move out of low yielders and into higher yielding currencies. The market has completely shrugged off this morning’s weak U.S. GDP report and news that more banks may need capital injections based upon the government’s stress tests. No major threat stands in the way of a further improvement in risk appetite which should mean further gains for USD/JPY.