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Roger J Kerr says global sentiment is returning in favour of the US dollar

Currencies
Roger J Kerr says global sentiment is returning in favour of the US dollar

By Roger J Kerr

Global investment markets and currency traders/speculators appear to have returned to the “risk-on/risk-off” mode of operation over recent times.

When sharemarkets and commodity markets are rising in value, the FX trades of preference are to buy the commodity/growth currencies such as the Canadian dollar, Australian dollar and also the Kiwi dollar.

When the equity and commodity markets are heading south, those currencies are sold in preference for the safe-haven investment destinations of the Japanese Yen and Euro.

When there is turmoil in the world (geo-political or economic) the previous paradigm was to always buy the US dollar as it was the safest reserve currency to be in. That maxim is not as strong as it used to be as increased global risks now seem to send investment funds home to places like Japan and Europe.

These investment capital flows have caused one of the real conundrums in today’s forex markets with the recent Yen and Euro strength at total odds with what the two respective central banks are attempting to do i.e. weaken their currencies.

The Japanese and European monetary policies of quantitative easing (QE) and negative interest rates are designed to supply more of their currencies into the market to debase the exchange rate values. Increase the supply of any good, stock or commodity and the value should decrease as supply exceeds demand. Currently that market theory is not working out too well for the Japanese and European central banks.

The Bank of Japan continues to threaten direct intervention in the FX markets to depreciate the Yen’s value. The threats will be regarded by the markets as hollow unless action follows the words very soon.

However, the JPY/USD exchange rate has returned to 110 from 105 (weaker Yen) over recent weeks as the financial markets lift the probability that the US Federal Reserve will increase their short-term interest rates again in mid-June.

As expected in earlier columns, the Euro could not sustain gains above $1.1400 and currently trades back at $1.1200.

Whilst US economic data was marginally on the weaker side in the March quarter, employment and retail sales numbers appear to have bounced back strongly in the June quarter.

Global equity markets are much less volatile than earlier in the year and thus the Federal Reserve now seem less concerned about global market/economic risk affecting the US economy in a negative way. The US dollar should continue to make gains against all currencies in the lead up to the mid-June Federal Reserve meeting.

One of the global risks Federal Reserve head Janet Yellen was concerned about back in March was the possibility of the UK referendum on 23 June voting to exit the European Union. That risk appears to have also reduced with recent political opinion polls in the UK starting to favour the “stay” camp.

The Pound Sterling exchange rate has settled in the $1.4400 to $1.4600 area against the USD after initially depreciating from $1.6000 to $1.4000 when it seemed the chance of a Brexit was likely. The Pound has subsequently recovered somewhat, however, the referendum result will still be a binary outcome with the Pound depreciating sharply to below $1.4000 if it is a “leave” result and strengthening on a “stay” outcome.

The US sharemarket bull run is certainly losing momentum with the market highs on the various indices of a year ago having not been exceeded over the last 12 months.

Recent US company profit results have been on the softer side and with the prospect of another Fed hike of interest rates suggests a weaker Wall Street over coming months.

Metal and mining commodity prices have reversed back down again as the speculative buying which pushed them up in March/April was mostly hot air (as anticipated).

The Australian dollar has continued to weaken on the back of the lower commodity prices and lower interest rates. The NZ dollar has not depreciated to the same extent, pushing the NZD/AUD cross-rate up to 0.9350.

The higher cross-rate to the AUD has kept the Trade Weighted Index (TWI) value of the New Zealand dollar up at 73.00, which is 7% above the RBNZ’s assumed TWI value of 68.00 for this time. For this reason the RBNZ should be seriously contemplating a further cut in the OCR to 2.00% at the June 9 Monetary Policy Statement. The NZD/USD rate is well overdue to catch up on the drop in the AUD/USD rate from 0.7800 to 0.7200 over recent weeks.

There are two likely catalysts to cause independent NZ dollar selling in the currency markets over coming weeks that will result in a lower NZD/USD rate, a lower NZD/AUD cross-rate and thus a lower TWI index:-

  • Fonterra releasing their 2016/2017 season’s milksolids payout forecast which will be in the $4.50/kg region for a third year in a row. Financial stresses and cashflow difficulties in the dairy sector will hit the media headlines and underline a major risk for the New Zealand economy that has to date been disguised and overshadowed by buoyant conditions in other industry sectors.
  • The RBNZ (hopefully understanding the importance of the dairy industry to the wider NZ economy) realising that they need to back their words of the need for a lower exchange rate with decisive action by cutting the OCR on June 9. The moneymarkets have now priced-out virtually any probability of a cut. The milksolids payout forecast should increase that probability again over coming weeks.

A return of the NZD/USD rate to the 0.6500 region over coming months will help dairy farming incomes, lift inflation back to within the 1% to 3% band and keep the export economy competitive. In the medium term beyond 12 months, improving international dairy prices should push the Kiwi dollar back above 0.7000.

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Source: CoinDesk

 

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

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8 Comments

Good thoughts Roger. I have found myself wondering whether there has ever been a time, since the US dropped Bretton Woods, when the fundamentals of an economy have been so completely disconnected to its currency valuations.

My own thought is the best tools for measuring currency patterns in the near future might end up being fluid dynamics. There seems to be so much excess liquidity that the system seems almost unresponsive to historic stimuli until it is placed under pressure.

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Fluid dynamics is for engineers.
I think of the global financial system as bath half full of water and we are all paddling in it

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Yes it is. But don't you think concepts like the 'velocity of money' sound suspiciously like fluid dynamics?

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Absolutely.
But hands up everone who understands the implications of M1 M2 and M3 and velocity on liquidity.
Hint, its nothing to do with plumbing...or motorways.

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Lol, velocity of money is just one way it seems to me to fit. They way the risk on/risk off mechanism alters the flow direction and its effects I also like.

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It's obviously not any kind of perfect fit, but some tools are better than no tools.

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Good thinking,
Ill do some.

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Nick Smith would need some special education to understand that.

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