How the NZD/USD exchange rate will react to recent global seismic shifts

How the NZD/USD exchange rate will react to recent global seismic shifts

By Roger J Kerr

There has been extreme and diametrically opposed views expressed already today on what the US credit rating downgrade means for the NZD/USD exchange rate direction.

The Prime Minister thinks initially up (from 0.8430) on a weaker USD scenario.

He should be more careful not to express such a public view on the NZ exchange rate in my opinion.

Mark Weldon, head of the NZ Stock Exchange sees short-term NZD downwards direction as global sharemarkets plunge and investors take more risk off the table - that is, risk aversion increases.

In the thick of a whirlwind of unpredictable global events, here is my summation of the positives and negatives for the NZD/USD exchange rate from here.

The NZD positives

- Global investment managers are forced to reduce USD denominated bond investments as their investment mandates from their sponsors decree that a AA+ credit rating has a lower percentage of total portfolio than AAA. Such managers will (in theory) be forced to sell USD’s as they reduce USD bond holdings. The problem with this is where else do they put their funds?

- FX markets sell USD’s against all currencies as they anticipate the investment re-weightings mentioned above. The argument against this is that Bank of Japan and G7 central banks may well intervene directly in forex markets to reduce currency market volatility as a result of the US and European debt problems.

- New Zealand is the only sovereign borrower alongside the US with a split credit rating, AA+ from Standard & Poors and AAa from Moody’s. Given our 10-year Government Bond yields at 4.50% against the US yields at 2.56%, investment funds should favour NZ bonds.

- The NZ Government finances are in much better shape than the US, UK and Europe and our economy is now much more aligned to selling food to Asia. Therefore, on sound economic fundamentals the NZD should gain as funds are attracted here on safe-haven grounds.

The NZD negatives

- A weaker US economy, problems in Europe and monetary tightening in China all add up to a weaker global economic growth story. The consequences for both the NZD and AUD from that scenario are interest rate increases are removed from moneymarket forward pricing and commodity prices fall.

- Plummeting global equity markets over coming days have to be negative for the commodity / growth currencies. The NZD/USD rate decoupled from movements in the Dow Jones Index in the weeks preceding the US debt ceiling fiasco. That situation has now changed and I would see the NZD following sharemarkets down over coming days/weeks. Global investors have to be reducing risk levels and this is always negative for the NZD.

- Chinese economic data being released tomorrow (industrial production, inflation and retail sales) is primed to be interpreted negatively by the commodity markets if there is a hint of the strong Chinese growth abating. Lower commodity prices equates to a lower NZD and AUD.

- The local interest rate markets are no longer pricing any increase over the next six months. The Australian short-term interest rate market is pricing 1.50% of reductions over the next 12 months. The rationale for global investors continuing to hold AUD’s is no longer there.

- The probability percentage of the global economy falling into another recession has just increased with the developments of the last few days. I don’t think that will happen, however the markets are now super cautious. The previous high-flying, favoured currencies of the NZD and AUD are at greater risk to selling than being bought in this environment in my view.

- The Japanese will continue to intervene (with help from other central banks if need be) to stop the Yen strengthening below 77.00 against the USD. The AUD/USD exchange rate follows the JPY/USD rate and right now the higher probability has to be a Yen above 80.00 to the USD and the AUD dropping towards $1.0000.

On balance ...

Overall, my conclusion is that the NZD negatives outweigh the NZD positives.

It is really hard to draw definitive conclusions or recommendations to USD importers/exporters with currency risks in these volatile and uncertain times.

Local USD exporters are best advised to implement a trailing/sinking-lid stop-loss hedging strategy to ride the NZD/USD lower with protection on the top in case it reverses out of the new downtrend. While the NZD/USD rate is between 0.8000 and 0.8500 collar options are the preferred hedging method for exporters, below 0.8000 forward contracts can start to be applied.

The long-term NZD/USD trading range is now arguably 0.7000 to 0.9000, having moved up from the previous 0.6000 to 0.8000 range.

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* Roger J Kerr runs Asia Pacific Risk Management. 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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