Playing chicken with the markets

AAP

Last updated 11:05 20/11/2009

Philosopher Bertrand Russell considered the game of chicken, where two opponents dare the other to change course or risk calamitous collision, as one played by "irresponsible boys".

In politics, this pastime is usually called brinkmanship and considered a fine and honourable tradition conducted by eminent adults.

But as Russell, an influential pacifist, noted, governments playing chicken have engendered at least one world war and numerous other conflicts with disastrous results.

Economists play chicken too, although for them it is an influential game theory and used as a model of conflict situations. The game is also called hawk-dove, the terms used to describe central bank utterances on monetary policy. If policy leans towards an easing bias, it is dovish; a tightening bias is hawkish.

Reserve Bank governor Alan Bollard, of late a committed dove, has been playing a grand game of chicken with the markets over the official cash rate these past few months, although who changes course first won't be known until January at the earliest.

Last week's publication of the biannual financial stability report saw Bollard continue to press home his message that economic conditions in New Zealand remain fragile and further growth is dependent on a number of internal and external factors, particularly the future trajectory of the New Zealand dollar.

He said much the same in a speech to the Trans-Tasman Business Circle in Auckland the week before and, five days prior to that, in the official cash rate announcement on October 29.

Bollard isn't blinking; he promises to keep the rate at its historic low of 2.5 per cent until the second half of the year.

The market reaction to the governor's dovish remarks, notes David Tripe, Massey University's head of banking studies, was interesting. "There's some reluctance to believe some of the commentary around when interest rates are going to rise," he observes. "Quite soon after the OCR announcement and commentary, [wholesale swap] rates were down.

"This week, they're effectively back up to where they were. That's an indication that the markets took a breather for a week and then decided that there's something still to be sorted out."

The market doesn't believe the Reserve Bank can wait until June or July to raise rates and has priced in an earlier move. It is, effectively, calling Bollard chicken.

It is a high-stakes game; traders stand to lose a lot of money if the governor holds the line.

Senior strategist at Toronto Dominion (TD) Bank Annette Beacher wouldn't use such language to describe Bollard but she sees a contradiction in his fretting about the mix of growth away from exports towards domestic demand, particularly renewed housing activity, and his insistence that the emergency cash rate level remains in place.

"While the Reserve Bank can do very little about the New Zealand dollar, a fact the prime minister [John Key] and finance minister [Bill English] have voiced for the last two weeks, it can indeed manage domestic demand," says Beacher, who covers the Australian and New Zealand beat for the Canadian bank from Singapore.

"There is a real risk of repeating the 2003 error, when cash rates were lowered in quick succession to insure against the then drought, electricity crisis, Sars trifecta," she continues. "Unfortunately it took a cash rate of 8.25 per cent to squash the subsequent housing boom. We doubt that Bollard will want to risk that boom-bust housing cycle into 2010."

The governor's concern is an early indication to the market that it has commenced a tightening bias that will see the dollar soar even higher against the greenback and pound. By holding his ground, he hopes to minimise the damage inflicted upon the export sector caused by the high-flying kiwi.

Some relief may come from the reduced appetite for New Zealand denominated debt from Asian and European investors, the so-called Japanese housewives and Belgium dentists. As Bollard notes in the stability report, maturities in urudashi and eurokiwis have greatly outweighed issuance this year.

Also helping will be the migration of mortgages to floating rates. As of September, reports BNZ chief economist Tony Alexander, 23 per cent of rates were floating compared to 13 per cent a year earlier. Further, much of the fixed lending is for shorter terms six months to 18 months. This will allow quicker transmission of monetary policy, he says, when Bollard eventually does tighten.

Alexander believes the governor will win his game of chicken. The markets can price in a tightening move as much as they want, he says, but the Reserve Bank will hold rates until mid-2010.

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Nick Smith is a senior financial journalist

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