By Roger J Kerr
Last week attached to this commentary was a chart of the whole milk powder prices (WMP) plotted against the overall New Zealand “Terms of Trade” Index (export and import prices). The correlation between WMP and the Terms of Trade is high (77%) due to the dominance of dairy products as our main export commodity.
The 20% plunge in WMP prices from USD5,000/MT to USD4,000/MT at the latest Fonterra/GDT on-line sales auctions over recent weeks points to the Terms of Trade Index following suit, likely to reduce from the current 1380 level to 1250 over coming months.
The New Zealand dollar Trade Weighted Index (TWI) is in turn reasonably correlated to the Terms of Trade Index (65% over the last 25 years), thus it is entirely reasonable to assume that the TWI is looking down the barrel of a similar 10% depreciation to the Terms of Trade, to below 70.00 from the current 80.23 level.
No-one is forecasting or suggesting such a dramatic fall in the value of the NZ dollar at this time due to the superior economic performance we are currently enjoying. However, it does pay to remember that our economy is narrow-based (as the IMF and S&P keep reminding us) and highly dependent on a small number of primary export commodity prices. The economy and currency go where they go.
The foreign exchange markets do not, as yet, appear to have realised the significance of the sharp falls in WMP prices. Australian and US currency market factors are dominating NZD day-to-day movements for the meantime, however in the medium term there is no getting away from the inevitable price/economic linkages and correlations.
There is no question that the previous super high WMP prices at USD5,000/MT did attract additional and new supply onto the globally traded milk powder market and this has occurred a lot earlier this year than what most local dairy industry pundits expected.
The New Zealand dollar at the current 0.8600 NZD/USD exchange rate, in my view, is in the twilight/overshoot zone where the short-term “carry-trade” demand outweighs and ignores the medium term underlying drivers of the currency’s real value. It will only take a turn in global investor market sentiment to change the attitude towards the high flying NZ dollar. Latest developments on Wall Street with serious questions over the value of tech stocks could prove to be the catalyst for a sizeable correction down in global equity indices.
That would be negative for the NZ dollar as investors everywhere remove risk form the table. It also requires a continuation of strong US retail and building sector data over coming months to confirm the timing of US short-term interest rate increases in early 2015. Adding the changing US environment of increasing US interest rates and an appreciating US dollar value to the plummeting export prices in New Zealand points to only one outcome for the NZD/USD exchange rate.
If the NZ dollar TWI does not follow the Terms of Trade Index/WMP prices down over coming weeks, the divergence would be very negative for our GDP growth outlook and that in turn would cause a RBNZ re-think on inflation risks and OCR increases. Whatever way the timing happens, NZD depreciation is inevitable.
USD importers should be forward hedged to the hilt!
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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