NZ and Aussie dollars losing yield allure

WELLINGTON/SYDNEY (Reuters) - The New Zealand and Australian dollars, once top favorites of yield-seeking investors, are falling from grace as stumbling local economies lead markets to price in major cuts in interest rates.

The New Zealand currency, or the kiwi, has fallen to 10-month lows after the Reserve Bank of New Zealand cut rates for the first time in five years last week in the face of an economy widely seen to be in recession.

With the central bank expected to cut rates to 7.25 percent by Christmas from 8 percent now, and to continue slashing them through mid 2009 to 6.5 percent, analysts say betting on a weaker kiwi is the obvious call.

"With interest rates in New Zealand falling pretty quickly, we'll be seeing a lot of carry trade flows shifting to other currencies," said Shamubeel Eaqub, director of investment research at Goldman Sachs JBWere.

That might also be a taste of things to come for the neighboring Australian dollar.

Just a month ago investors were bracing for another rise in Australian rates, already at a 12-year high of 7.25 percent. But a string of weak economic numbers, a slumping share market and a collapse in borrowing have changed all that.

The ever-vigilant Reserve Bank of Australia is now saying domestic demand is cooling as desired and inflation should recede in time.

As a result, the market is now pricing in at least 50 basis points of cuts in the next 12 months. Meanwhile, the gap between Australian and U.S. two-year bond yields has shrunk to 368 basis points, its smallest since December 2007.

Stephen Halmarick, co-head of economics and market analysis at Citi, said he now expects Australian rates to drop by 75 basis points in the first half of 2009.

"The risk is tilted towards the bank moving earlier rather than later if credit appetite and spending continue to weaken," he added.

Indeed, there were ominous signs of such scenario on Thursday when government data showed retail sales suffered their biggest monthly fall in six years in June.

CARRY TRADE

The two currencies, which offer some of the highest interest rates in the developed world, have long been favored by carry traders, investors who borrow in low-yield currencies to invest in high-yield ones.

Backed by such demand, the kiwi scaled a 23-year post-float high of $0.8215 in March while the Aussie struck a 25-year high of $0.9851 earlier this month.

Yet by Thursday, the Aussie was near six-week lows around $0.9440 and the Kiwi plumbed 10-month lows at $0.7340, while investors turned to currencies such as the South African rand and the Brazilian real which have interest rates of 12 and 12.75 percent respectively.

"Regardless of which currency you're buying in the Anglo-Saxon economies, you're buying into an extremely leveraged housing downturn," said Eaqub at Goldman Sachs JBWere.

"This potentially means that the economic downturn we are going to see will be protracted and deeper than we have seen for some time."

Speaking to a business group on Wednesday, New Zealand central bank chief Alan Bollard said there was "plenty of room" for further policy easing.

Analysts in a Reuters poll predict the kiwi to fall to $0.70 by the end of 2008 and to slide to $0.66 by September next year in step with falling interest rates.

In Australia, some analysts forecast the Aussie dollar could fall 10 percent to around $0.85 by the end of the year, hit by a slowdown at home and easing prices of its key commodity exports. The cooling in domestic demand comes at a time when the global financial sector turmoil has hit home with local banks unveiling more credit-related losses.

Earlier this week, the Australia and New Zealand Banking Group joined the country's largest lender, National Australia Bank, in disclosing increased losses from exposure to distressed credit markets.

With the banks hoarding cash, households and businesses in Australia are finding it harder and harder to borrow.

"Bank lending has now slumped, dropping by about one-quarter from its recent high," said Kieran Davies, chief economist at ABN AMRO.

"This broad-based weakness leads us to factor in an increased risk of recession," he warned. "This has seen us shift from rates remaining on hold to factoring in a 25 basis-point rate cut in the fourth quarter, with a further two cuts in the first half of next year."

(Editing by Wayne Cole and Tomasz Janowski)