Easing third-quarter inflation weighs on New Zealand Dollar

• NZD/USD finds it difficult to build on recent gains, with the Kiwi under pressure from softer New Zealand inflation figures.
• The pair's downside remains limited as lower US Treasury yields weigh on the US Dollar.
• With the Fed and RBNZ due to announce their decisions next week, traders are looking for fresh guidance on monetary policy.

NZD/USD's five-day advance stalls on Thursday, although selling pressure remains limited as falling US Treasury yields keep the US Dollar (USD) under pressure. Softer-than-expected domestic inflation figures have weighed on the pair. It is trading near 0.5686 at the time of writing, having retreated from the one-month peak of 0.5711 reached during the Asian session.

Demand for government bonds, driven by concerns surrounding AI-related investments, is pulling US Treasury yields lower across maturities and extending their retreat from multi-year peaks. After touching 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) is trading near 101.60 after hitting 101.45, its lowest level in three weeks. The index measures the Greenback against a basket of six major currencies.

Even with inflation risks skewed upwards, the sell-off in AI-related equities could cloud the Federal Reserve's (Fed) interest rate outlook. Higher energy prices linked to Middle East tensions remain a particular source of inflation risk.

Attention is turning to next week's Fed meeting, with the US central bank widely expected to hold interest rates steady. At the same time, market expectations of a further increase in December have moderated. 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 0.7% QoQ, against a forecast of 0.8% and the preceding reading of 1.5%. Annual inflation also undershot expectations of 3.8%, easing from 4.1% to 3.7%.

The softer headline figure has not dispelled concerns about underlying inflation, according to strategists at Brown Brothers Harriman, who note that "underlying inflation points to persistent price pressure." As evidence, they cite 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," and that "CPI ex. petrol remained at 3.2% y/y for a fourth consecutive quarter."

BBH sees a case for further tightening in this environment, arguing 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 caution, however, is that "NZD/USD upside is constrained because Fed tightening curbs the scope for policy convergence."