The first session and the start of the second belonged to the Sri Lanka bowlers, especially Suranga Lakmal who claimed the first four wickets to fall and had 5-52 by tea, his second five-wicket haul in tests.
New Zealand was 51-4 at lunch, having lost Jeet Raval (6), Tom Latham (10), Kane Williamson (2) and Henry Nicholls (1), and slumped further when Ross Taylor (27) and Colin de Grandhomme (1) fell early in the second session.
Watling and Southee put the Sri Lanka bowlers under pressure for the first time in the match, particularly Southee who unleashed an array of attacking shots. He took his 68 runs from 65 balls with six fours and three sixes.
Southee completed back-to-back half centuries on Hagley Oval after reaching the mark on the same ground against England in March. He was approaching his highest score in tests — 77, compiled on debut 95 innings ago — when he fell to a brilliant catch by Dimuth Karunaratne within sight of tea.
Neil Wagner (0) was out to the final ball of the session, swinging the day back, heavily, in Sri Lanka's favor.
Watling, who came to the crease when New Zealand was 34-6 before lunch, was 46 not out at the break.
Sri Lanka began the day by winning an advantageous toss and bowling first on a pitch which was green, moist and allowed seam movement. Lakmal was the only Sri Lanka bowler to fully exploit the conditions, employing a full length which made even slight seam movement dangerous to the batsmen.
Raval was out to a miscued shot, a leading edge to mid-off but Latham and Williamson — the critical wicket for Sri Lanka — fell to catches behind the wicket when the ball left the bat.
Nicholls was bowled by a superb delivery, angled into the batsman, which straightened between bat and pad.
The dismissals early in the second session were the result of bad luck of bad batting.
Taylor, who had looked in good touch, was run out at the non-striker's end when a straight drive by Watling was diverted onto the stumps by Lahiru Kumara.
De Gandhomme, whose best test form has been on Hagley Oval, threw his wicket away with a careless pull shot which left New Zealand 64-6.
Southee began with a series of flicks into the leg side then lashed out at the short ball and gained scoring momentum with a series of boundaries. He dashed to his fifth half century in tests from 43 balls.