Roger J Kerr says the caution being expressed by the US Fed is two months out of date

By Roger J Kerr

The Kiwi dollar continued to defy the Reserve Bank and the majority of currency pundits as it powered on ahead to highs of 0.6965 over the past week.

Yet again, it is a case of US dollar weakness rather than NZ dollar strength that has pushed the Kiwi out the top of its 0.6400 to 0.6800 trading range.

Worries coming out of the US Federal Reserve that offshore financial/investment market volatility and uncertainty reflects severe risks to the global economy and for these reasons they have to be more cautious and slower with increases in US interest rates.

The US dollar has weakened in response to the Fed’s utterings, with the EUR/USD exchange rate moving to $1.1400.

The Fed’s concerns would have been creditable and warranted in late January when global sharemarkets were tumbling. Over the past two months, however, markets have calmed and settled as they realise that the Chinese economy is not about to implode and the Chinese authorities implement monetary and fiscal stimulus packages to ensure they do not have a hard landing and maintain GDP growth at 6.5%.

The Fed’s words of late seem two months out of date and suggest that they have little confidence in the Chinese to manage their economic affairs.

The Fed have once again protected and fuelled Wall Street and weakened their currency at the same time.

Not everyone can have a weaker currency, as much as they would like to assist their export industries. The RBNZ in their last Monetary Policy Statement also put heavy emphasis on global market and economic risks as a supporting rationale to implement a surprise cut in interest rates.  The RBNZ also wanted to push the NZ dollar value lower. The global markets had already settled down and the surprise cut to the OCR has back-fired on the RBNZ with the NZD/USD rate and TWI Index both moving higher over recent weeks.

A major factor in the NZD gains to above 0.6900 has been the stellar performance by the Australian dollar which has continued to appreciate against the USD to 0.7660 on the back of higher metal and mining commodity prices.

The sharp increase in commodity prices does not look sustainable as there has been no change to global physical market demand and supply conditions. Therefore, the buying appears driven by financial players either closing down short-sold positions or speculating ahead that investors will seek returns from commodities as interest rates provide no yield return and equities may be fully priced.

Should the commodity rally reverse back down, the AUD/USD rate would head south and take the Kiwi dollar with it.

The AUD gains have also come on the back of statements from the RBA that they are pretty much done with further interest rate reductions. Similar central bank statements by the RBNZ (last December) and the ECB (a month ago) caused subsequent NZD and EUR gains.

Foreign exchange markets price the future economic and monetary environment 12 months ahead and it is time central bankers understood such FX market reactions to their words. The AUD has made spectacular gains from 0.7100 to 0.7660 over a very short period. One would have to think that profit-taking on long AUD positions is about due to force a correction downwards.

Not even a stronger than forecast increase in US jobs for the month of March (+215,000 compared to consensus of +205,000) could turn the current US weakness around. The US Manufacturing PMI index was also stronger than expected, jumping up to 51.8 (consensus 50.7) in March from 49.5 in February.

It seems inevitable that more Federal Reserve Governors will realise that the US economy is travelling very well and the global risks have moderated, therefore Fed Chairwoman, Janet Yellen’s extreme caution is out of step with the US domestic economic reality.

Based on the stronger US economy and adjustments by the US interest rate markets that there will still be hikes this year, the US dollar is set to turnaround. In turn, a stronger USD on the world stage will reverse the NZD/USD rate back to 0.6500/0.6600 to the relief of the RBNZ and unhedged NZ exporters.

Local USD exporters following our advice have been very well hedged through this period and should be sleeping well at night!

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com