Roger J Kerr says the FX markets are waiting to be told that the NZ economic fundamentals have weakened

 By Roger J Kerr

The foreign exchange markets have to date only partially re-priced the NZ dollar downwards in response to the dramatic plunge since March in the economy’s major export commodity price, wholemilk powder (WMP).

The WMP price continues to fall in the fortnightly Fonterra/GDT online dairy product auctions, trading to below USD3,800/MT from above USD5,000/MT only a few short months ago.

Local economists are now calculating that the much lower WMP price will reduce the 2014/2105 dairy season’s milksolids payout to somewhere near $7/kg, which in turn reduces dairy farmer income by NZD3 billion compared to last season and lops near to 1.00% of our GDP growth.

The economic ramifications are serious and the WMP price adjustment will be playing a big part in the RBNZ’s revised GDP growth forecasts due out on 12^th June.

The Kiwi dollar has recoiled from its highs of 0.8770 to trade 2.6% lower at 0.8540. However, WMP prices have dropped 23%, thus the NZ dollar still has a long way to catch up.

There is nothing to suggest that WMP prices will recover anytime soon, indeed increased European milk powder supply onto the globally traded market later in the year as regulatory restraints are removed points to even lower prices.

A major risk to New Zealand’s economic fortunes is unfolding before our eyes.

Up until two weeks ago a steady stream of capital inflows attracted by New Zealand’s increasing short-term interest rates (“carry-trades”) were more than countering any NZ selling stemming from the plummeting WMP prices. Thus the Kiwi dollar remained at its elevated levels.

However, today the mood and sentiment in the Australasian forex markets is now shifting to a more negative bias and it appears that the earlier carry-trades are being unwound i.e. NZD and AUD selling.

Two developments over the last two weeks have caused this re-assessment by global currency players towards the NZD and AUD:-

1. RBNZ Governor, Graeme Wheeler has warned the markets that it would be “opportune” to intervene in the markets to bring the NZ dollar down if the divergence between the NZD/USD exchange rate and the economic fundamentals (i.e. export prices) continues. So far, the divergence has continued and therefore the markets must be starting to anticipate that the RBNZ will do something about it at the 12 June Monetary Policy Statement.

Outright interventionist selling of the NZD across the FX markets is not expected.

In addition, not many commentators are really expecting a surprise cancellation of the well-telegraphed third 0.25% OCR increase. However, that form or intervention would certainly send the NZD down two or three cents and such a decision cannot be totally ruled out.

The more likely outcome is a 0.25% OCR increase to 3.25%, however in the same breathe the RBNZ revise down their GDP growth and inflation forecasts, therefore removing further OCR increases in 2014 from the guidance track they delivered in March.

2. While the AUD was not immediately sold down on the Australian Budget on 13 May, the plunge in consumer confidence due to the health and education spending cuts contained in the budget has since caused AUD selling. The RBA is become slightly more dovish in their outlook on the Australian economy and now do not see the need for any interest rate increases at all over the next 18 to 24 months.

Exports from the mining and resources sectors have increased strongly as a result of the large capital expansion projects that have been completed in recent years; however there is not any increase in employment to counter the jobs that continue to be lost in many manufacturing industries in Australia. The Australian dollar has reversed from its gains to 0.9400 against the USD in April and appears to have a soft underbelly making it vulnerable to further selling.

It has been surprising that the NZD/USD exchange rate has not already depreciated further in response to the falling WMP prices.

Perhaps the FX markets are waiting to be told more explicitly by the RBNZ on 12 June before reacting.

Ahead of the RBNZ Monetary Policy Statement, the earlier ECB announcement on 5 June to reduce their interest rates and embark on a European-style quantitative easing monetary programme will be exerting downward pressure on the EUR/USD exchange rate.

A weakening of the Euro from $1.3600 towards $1.3000 in response to the European monetary policy loosening must also act to pull the NZD/USD rate lower. 

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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