After spending most of the night in decline, the NZD/USD shot up around � cent this morning as investors bashed the USD following a surprisingly dovish FOMC statement.

The upshot is that the NZD/USD, at around 0.8135, is actually higher than this time yesterday.

The USD and US bond yields were slammed on the release on this morning's FOMC statement. This followed the Fed's surprise commitment to keep interest rates "exceptionally low" until late 2014. Along with the rest of the major currencies, the NZD was dragged higher against a broadly weaker USD (see majors).

Yesterday's firm Australian CPI figures lit a rocket under the AUD. Headline CPI undershot market expectations (flat vs. +0.2%q/q expected). But signs of solid underlying inflation (trimmed mean +0.6%q/q) saw Australian markets trim bets for a February RBA rate cut, from 85% prior to the CPI release, to 65% currently.

As Australian interest rates rose across the curve the AUD/USD was propelled from 1.0480 to 1.0530, knocking the NZD/AUD around � cent lower to 0.7700.

We noted yesterday that the NZD/AUD was starting to look "expensive" on a fair-value basis. This remains the case even after yesterday's sharp fall in the cross. While the NZD/AUD has fallen, "fair-value" has also edged lower (to a 0.7500-0.7700 range), driven by narrowing NZ-AU interest rate differentials (the most important driver in the valuation model). NZ-AU 3-year swap differentials slipped from -105bps to -115bps yesterday, knocking around � off our model's fair-value estimate.

The key near-term focus for the NZD is this morning's RBNZ interest rate decision. While the OCR will almost certainly be held at a record-low 2.50%, expect some softer rhetoric from Governor Bollard. After all, the Q4 CPI was weak and momentum in parts of the domestic economy has slowed.

The currency is sure to come in for some attention too, given the NZ dollar TWI is a whopping 7.2% above the RBNZ's December predictions. We doubt any such hand- wringing will have any lasting effect on the currency. Global risk appetite and USD sentiment remain the dominant drivers of the NZD/USD in the current environment.

Lastly, with Aussie markets closed for Australia day, liquidity in the NZD market will be reduced today. This raises the chances of a more volatile NZD reaction to the RBNZ statement at 9am.

Majors

It's been a wild ride in currency markets over the past 24 hours. After starting the night on the front foot, the USD back peddled sharply following the release of the FOMC statement.

The key take out from the Fed statement was the pushing out of their commitment to maintain interest rates at "exceptionally low levels" from the December statement's mid-2013 to "late 2014". Elsewhere, the statement was more or less a reprint of the December 13 edition. It seems the Fed does not share global investors' more upbeat view of the US economy. Notably, Richmond Fed President Lacker (a noted hawk) dissented against the decision to include the time commitment.

The prospect of ongoing monetary stimulus saw US bond yields and the USD tumble. Indeed, US 10-year Treasury yields ended the night down almost 10bps at 1.96%, providing headwinds for the USD.

Against the broadly weaker USD, the EUR and GBP popped almost a cent higher to 1.3100 and 1.5630, respectively. At the same time, USD/JPY unwound nearly all of the night's previous gains, sliding from 78.20 to around 77.70.

The implications of this dovish statement are likely to morph over the coming hours. Initial knee-jerk fear that the Fed has not embraced the up-turn looks like it can fuel a 'what does the Fed know that we don't' suspicion. However, over the coming hours we would expect markets to move back from the fear factor and to embrace the idea of an easier (possibly QE3-bound) Fed. The combination of the current glass is half full mood and a looser Fed should act to support investors' risk appetite and "growth sensitive" currencies (the S&P500 is currently up around 0.5%). We would therefore look for the USD to extend its losses in the coming hours and EUR/USD may yet reach 1.3075-1.3150, with the AUD/USD possibly testing 1.060.

Prior to the FOMC statement, the USD had been on the ascendancy. Not only did "safe-haven" demand underpin the currency, but the EUR/USD suffered a sharp fall.

Headlines suggesting European officials are "losing hope" for agreement on the Greek debt swap deal (seen as critical to Greece avoiding default) and the ECB may have to take a hit on its Greek bond holdings dented sentiment during the European trading session. European equity indices mostly fell and the EUR/USD was knocked around � cent lower to 1.2950. A solid German IFO reading (105.4 vs. 102.9 expected) did help steady the EUR somewhat.

Fixed Interest

There was a gentle further rise in NZ yields yesterday. Early this morning, the FOMC statement pushed out the probable starting point for US rate hikes to late 2014.

Yesterday, NZ swap and bond yields closed up 2-4bps across the curve. The yield on 2-year swaps inched up to 2.86% and that on 5-year to 3.47%. Swap bond spreads remain comfortably below 30bps, with 10-year EFP at 28bps.

In NZ bond markets, yields closed up 3-4bps, dragged a little higher by the rise in Australian bond yields. AU 10-year bond yields rose around 8bps, to almost 4.00%, after the AU CPI release. The market focus was squarely on higher than expected underlying inflation. However the market continues to price almost 100bps of cuts from the RBA in the year ahead, expectations we believe are too aggressive. We expect a further rate cut from the RBA in early Feb, taking its cash rate to 4.00%.

US 10-year yields dipped ahead of the FOMC announcement early this morning from 2.07% to 2.01%. The Fed's dovish statement (see majors) then saw US 10-year yields fall further to around 1.94% currently, though still comfortably in the middle of recent ranges.

The Fed's policy of keeping rates exceptionally low, and to continue extending the duration of its securities holdings will likely see US long yields stay low for some time. This will occur despite some broader improvement in US economic data in recent months. In turn, this will keep NZ long-end yields lower than local fundamentals would dictate.

Today's local focus will be the RBNZ meeting. We expect the RBNZ will once again play a fairly steady hand. It will likely continue to suggest medium-term tightening bias, but acknowledge the recent welcome fall in recorded inflation, and ongoing global uncertainty.