[achiever]

AUD/NZD has probably been one of the most frustrating crosses for investors trading off of relative interest rate dynamics in the past year. Its historically high correlation with interest rate spreads fell from above 80% to negative 40%. At the same time, the historically low correlation with equity returns jumped from 10% to 50%. But if equity returns become less relevant for this cross again and domestic fundamentals resume as the main driver, the contrasting stance of RBA versus RBNZ evidenced last week suggest the 90 day interest rate spread could widen from 50bps to 150bps over the next 6 months, and pave the path for a move above 1.30.

RBA to drop easing bias this week
Following RBA Governor Stevens’ upbeat speech on “Challenges to Economic Policy” on 28 July, some expect the RBA will drop its easing bias this week by removing the key phrase that there is “scope for some further easing of monetary policy” and shift to a firmly neutral stance, paving the way for a start of a normalisation of rates. This will be followed by likely upward revisions to growth in the SoMP on Friday. In contrast, the RBNZ retained its easing bias and delivered a dovish statement on 30 July by stating “The OCR could still move modestly lower over the coming quarters. Analysts continue to expect to keep the OCR at or below the current level through until the latter part of 2010."

Some market analysts suggest that RBA will be one of the first to hike among the G10 since policy is well ahead of the curve and policy rates are already ~120bp below neutral. In contrast, NZ cash rates are 10bps below neutral. If the RBA move to a neutral policy stance this week as the RBNZ maintains its easing bias, there is scope for the short term interest rates differential to widen in AUD’s favour. The current forecasts suggest the 90 day spread could blow out from 50bps to 150bps over the next 6 months. If the rolling correlation with interest rates normalises, traders expect increasing sensitivity to interest rate dynamics will push AUD/NZD above 1.30.