Easing third-quarter inflation weighs on New Zealand Dollar

• Softer New Zealand inflation figures weigh on the Kiwi, leaving NZD/USD struggling to build on recent gains.
• The pair's downside is cushioned by lower US Treasury yields and a softer US Dollar.
• Next week's Fed and RBNZ decisions are in focus as traders seek further guidance on monetary policy.

Weaker-than-forecast inflation figures from New Zealand interrupt NZD/USD's five-day run of gains on Thursday. Selling pressure has nevertheless failed to gather momentum, with falling US Treasury yields keeping the US Dollar (USD) under pressure. Having reached a one-month high of 0.5711 in the Asian session, NZD/USD has eased to around 0.5686 at the time of writing.

Concerns about AI-related investments are encouraging demand for government bonds, pushing US Treasury yields lower across the curve and extending their retreat from multi-year highs. After hitting 5.36% earlier this month, the benchmark 10-year US Treasury yield has dropped below 5.00%, a decline of around 15 basis points (bps) on the day. The US Dollar Index (DXY), which measures the Greenback against a basket of six major currencies, meanwhile stands near 101.60, having earlier reached a three-week low of 101.45.

Although inflation risks remain skewed to the upside, the sell-off in AI-related equities could make the Federal Reserve's (Fed) interest rate outlook more complicated. Higher energy prices, amid Middle East tensions, are a particular source of those inflation risks.

Attention is turning to next week's Fed meeting, at which the US central bank is widely expected to hold interest rates steady. The prospect of another rate rise in December has, however, receded: the CME FedWatch Tool puts the probability at 67.6%, compared with around 89% earlier in the day.

Third-quarter inflation in New Zealand slowed by more than markets had anticipated. The Consumer Price Index (CPI) increased by 0.7% QoQ, against a forecast of 0.8% and a previous reading of 1.5%. Annual inflation fell from 4.1% to 3.7%, below market expectations of 3.8%.

Despite the weaker headline figure, Brown Brothers Harriman strategists note that "underlying inflation points to persistent price pressure." They draw attention to the fact that "the RBNZ sector factor model printed at 2.8% y/y for a second straight quarter, near the top of its 1-3% target range," alongside their observation that "CPI ex. petrol remained at 3.2% y/y for a fourth consecutive quarter."

In light of these figures, BBH maintains that "above target inflation and still elevated oil prices argue for additional RBNZ rate hikes." On market pricing, the strategists note that "the swaps curve price in 85% odds of a 25bps RBNZ rate hike to 3.00% on October 28 and more than 100bps of tightening over the next twelve months to 3.75% - near the upper end of the RBNZ’s estimated neutral range of 2.20%-4.10%." Their caveat, however, is that "NZD/USD upside is constrained because Fed tightening curbs the scope for policy convergence."