An exchange rate forecast note from BK Asset Management has picked the New Zealand dollar to be one of the leaders in global FX in 2014.

Yesterday we reported on why the GBP is likely to do well in 2014, today we hear that the New Zealand dollar is also forecasted to be one of the outperformers in 2014 thanks to high New Zealand interest rates.

Kathy Lien of BK Asset Management sheds more light on the matter below.

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Forecasts for the New Zealand dollar in 2014

EUR/NZD – Looking for a move to 1.60 (Currently 1.69)GBP/NZD – 1.90 Target for GBP/NZD (Currently 2.02)NZD/USD – Bottom at 80 Cents, 80/85 RangeAUD/NZD – Sell-off Could Stall at 1.05

The New Zealand dollar has the potential to be one of the best performing currencies next year.

While the combination of Fed tapering and RBNZ tightening could limit the rise in NZD/USD, we believe there’s scope for stronger gains versus the AUD, GBP and EUR.

NZD/USD forecast

We expect NZD/USD to bottom around 80 cents in the beginning of the year and then range trade between 80 and 85 cents in the coming year with a move towards the upper end of this band around mid February / March. After having fallen aggressively in 2013, the sell-off in AUD/NZD could be limited to 1.05 and there’s a high probability that the currency pair will drop to that level.

Parity is possible especially if the RBA eases around the same time that the RBNZ tightens. We expect the biggest gains for NZD to be against the EUR and GBP. 1.60 is possible for EUR/NZD while a move to 1.90 for GBP/NZD is likely.

NZ economic growth to underpin NZ dollar

The growth in New Zealand has been driven primarily by recovery. In Q3, farm output surged on drought recovery and throughout the year, the country also benefitted from rebuilding following the 2011 Christchurch earthquake. It is important to remember that New Zealand is a very small economy and major infrastructure projects can have a significant impact on growth.

For the year ending March 31, 2014, the country is expected to grow at an annualized pace of 2.7% and according to the Treasury’s Half Year Economic Update, this growth is expected to rise to 3.6% in the year to March 2015. Additional work on the city centre, major projects such as a convention centre and stadium along with the development of precincts dedicated to health, technology and culture will contribute to growth.

Recovery's base broadens

The recovery is also broadening beyond construction and housing. Residential and business investment along with growing demand for New Zealand’s exports should bring more jobs, higher wages, optimism and wealth.

Interest rate hike expectations

Above trend growth and a stubbornly strong housing market has the RBNZ worried about inflation. As recently as their December monetary policy meeting, the central bank said they would need to raise rates in 2014 to keep inflation near their 2% target

At a record low of 2.5%, New Zealand’s interest rate is more generous than any other major economy and in the coming year, the RBNZ will make buying the currency even more attractive and selling it more expensive. Aside from being the first developed nation to raise interest rates after the financial crisis, the RBNZ said they expect to lift rates to 4.75% (or 225bp) in 2.25 years time.

Demand for milk

The main reason why the outlook for New Zealand and Australia differ is because New Zealand produces a commodity that will see increased demand from China’s focus on domestic growth.

Approximately 90% of New Zealand’s milk powder is sold to China and as the middle class in China and India grow, their demand for milk and protein will increase.

Milk vs Iron: AUD vs NZD

While dairy and milk account for more than 35% of New Zealand’s exports, Iron Ore and Coal account for more than 35% of Australia’s exports. Unfortunately the development slowdown in China will hit the Australian economy hard in ways that do not affect New Zealand, which is why we believe AUD/NZD could drop to 1.05 and maybe even parity. Of course, Australia is still the country’s second most important trade partner and for this reason, New Zealand will not be immune to slower growth in Australia. However barring a severe slowdown, any decline in demand would be offset by stronger global growth and a rising middle class in the world’s most populated countries.