Economic Update
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The expansion of the conflict in the Middle East towards energy infrastructure has heightened the risk of a protracted global crisis. Markets remain volatile as participants digest the potential for long-term supply chain disruptions, specifically regarding the closure of the Strait of Hormuz. While a swift resolution remains the hope, the possibility of a longer war persists. Politically, while President Trump is pushing for Iranian capitulation toward a ceasefire and formal negotiations, Iran is countering by weaponising its control of the Strait of Hormuz to trigger global instability in commodity markets. Economically, the recovery timeline is tied directly to the conflict’s duration: a 5 to 6-week war suggests a 2 to 3-month normalisation period, whereas a 2 to 3-month conflict could delay the return of normal oil and gas supply by 6-12 months. As ECB President Christine Lagarde warned, “The real shock is probably beyond what we can imagine at the moment.”

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From a New Zealand perspective, the economic recovery remains tentative with December quarter GDP growth slowing to 0.2% and  missing the Reserve Bank of New Zealand’s (“RBNZ”) 0.5% forecast - despite a recovery in primary industries. On the year, GDP expanded at 1.3%. While the primary sector shows resilience, the construction sector remains a drag. Food price inflation is also becoming an issue, printing at 4.5% in the 12 months to February, up from January’s 4.2%. The RBNZ signalled it will largely look past a temporary spike in energy prices from the conflict but warned the Official Cash Rate (“OCR”) could rise if inflation proves more persistent. Governor Anna Breman stressed that the duration of the shock is critical as policymakers needed to weigh the inflationary pressures against slower growth, stating, “A short-lived disruption and a temporary increase in petrol prices can – and should – be looked through … if unlikely to affect medium-term inflation.” However, if higher energy costs begin to shape inflation expectations, “The appropriate policy response could be to increase interest rates to prevent these second-round effects.” The Governor also flagged rising uncertainty for households and businesses, arguing that targeted fiscal support would be more effective than monetary policy in cushioning the impact.

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New Zealand Interest Rates: 

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Fears of a massive energy-driven inflation shock has seen interest rate yields and swap rates surge higher as the focus shifts from a ‘temporary inflation shock’ to concerns of a ‘sustained inflation risk.’ Globally, the spike in 2-year yields suggested markets had been pricing in a ‘sticky inflation’ premium, although this has started to reverse as the possibility of a longer, more drawn-out conflict increases.

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While the correction in US yields has weighed on NZ swap pricing, it should be noted that the local rally in swap pricing outperformed the US rally driven by increasingly illiquid markets and a cost given our over-reliance on imported fuel. Since the start of the conflict, the 2-year swap rate has surged from 2.95% to a high of 3.68%, before its recent retreat to 3.40%, while the 4-year has moved from 3.36% to 4.09%, before easing to 3.82%. The floating rate, 3-month BKBM, remains stable in the low ~2.50% area, and the cheapest part of the curve. Current market pricing is implying an improbable four 25bps OCR hikes over the next 12-months on the pretext of rising inflation risks, a scenario that would certainly put any economic recovery hopes on ice. Stretched household budgets, subdued house prices, low immigration, benign wage inflation, food inflation at 4.5%, and, as the RBNZ referenced, “significant spare capacity,” will counter some of these pricing pressures while the rally in interest rate swap pricing has already provided a tightening by generating higher mortgage rates.

It should also be remembered the RBNZ’s mandate is “to keep annual Consumer Price Index (CPI) inflation between 1.0% and 3.0% on average over the medium term” which provides the Governor with an ability to ‘look through’ the war and associated inflation spike as it focuses on the medium-term.

NZD/USD:

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The NZD remains at the mercy of the latest headlines, with the USD and geopolitical tensions acting as the primary drivers. Since the start of the conflict, the NZD has been the weakest performing currency against the USD, with the Easter break contributing to this trend with the pair falling to a low at 0.5681. The bounce is potentially a re-test of the prior support range, which would imply the formation of a 0.5625 to 0.5745 range in the short-term. Given the NZD/USD has been the weakest performer during the conflict, it raises the question as to how far it could bounce on a ceasefire. A quick resolution to hostilities would likely trigger a relief rally for the NZD, however, the longer the conflict drags on, and the higher energy-driven inflation climbs, the greater the risk of sustained NZD weakness.