By Roger J Kerr
Oil prices, deflationary forces and Swiss surprises dominate sentiment and direction in the currency markets at this time.
A surprise Swiss monetary policy change sent foreign exchange markets into a tailspin last week.
Many factors can create market shocks and wild gyrations in FX markets as we have seen pre and post the 2009 GFC; however few would have expected that an abrupt and dramatic U-turn in the mechanism to stop the Swiss Franc appreciating by the Swiss central bank would be one of those factors.
Last week’s instantaneous reaction by the markets to the unprecedented Swiss National Bank announcement which saw the Swiss France soar 30% against the Euro within hours sent massive reverberations around global financial markets.
The Swiss central bankers suddenly abandoned direct intervention in the FX markets (buying Euro’s, selling Swiss Francs) as their method to maintain their currency at a certain value to the Euro, in favour of deterring buying of Swiss Franc by the market by increasing the negative interest rate their banks charge depositors for the pleasure of holding Swiss Francs from 0.25% to 0.75%.
The Swiss took this measure a week before the European Central Banks (ECB) are due to add to their money printing (quantitative easing) policy on 22 January.
Clearly, the Swiss do not want to continue to accumulate Euro’s, a currency that continues to depreciate due to deflation and ECB money printing.
The events of last Friday and the large losses caused by many participants in the forex markets highlights that risk taking with poor controls and limit systems remains widespread across the financial and investment markets.
Foreign exchange brokers have gone bust from London, to New York, to Auckland as client trading position losses exceeded client funds held and operations were ceased.
Hedge funds and bank proprietary trading desks were also caught out with value at risk (VaR) limit systems again being sorely tested by yet another event risk which caused intra-day exchange rate movement well beyond VaR model stress-test bands.
Currency market extreme volatility is nothing new; it is just that the source was never expected to be the Swiss central bank. It appears that many currency traders and investors around the world had protective limit and control systems with holes through them as large as Swiss cheese!
The NZ dollar gained against the USD on the European currency shenanigans as it would have been seen as a stable economy/currency well away from the turmoil in Europe.
On the day of the Swiss National Bank announcement the Kiwi dollar dipped to a low of 0.7713, than jumped up to a high of 0.7884 before returning to the 0.7750/0.7800 area.
On reflection over recent months, the NZD/USD rate has remained serenely within a relatively narrow 0.7600 to 0.7900 trading range whilst the Australian dollar has plunged from 0.8600 to 0.8100 (6% down) and the Euro has plummeted from $1.2500 to $1.1550 (7.5% down).
As a consequence of currency investors preferring the Kiwi over other currencies, the NZD/AUD and NZD/EUR cross-rates spiralled to highs of 0.9650 and 0.6750 respectively.
However, in recent days a severe bout of trader profit-taking in the NZD/AUD market has seen the cross-rate reverse from 0.9650 to 0.9450.
The interest rate differential between the Australian and New Zealand currencies still points to a more realistic NZD/AUD cross-rate of 0.9100. The extreme overshoot in the NZD/AUD cross- rate to 0.9650 was never going to be sustainable.
Despite numerous forecasts from local bank foreign exchange strategists that the Kiwi dollar would continue to depreciate to the low 0.7000’s in late 2014 and into 2015 due to a strong US dollar on global FX markets, the Kiwi has been singled out as an outperformer of other currencies due to its higher 3.5% interest rates and superior economic performance (despite sharply lower dairy prices).
The immediate outlook for the NZ economy does however have some threats with the dry summer weather adversely impacting on agriculture production.
Perversely, lower than expected NZ dairy production due to climatic reasons may assist a recovery in the wholemilk powder prices as supply is impacted.
It would appears that the FX markets have already priced-in further monetary loosening in Euroland with the Euro falling to $1.1550 against the USD, therefore additional significant Euro weakness may not eventuate when the fact is announced next week.
Given the likely stabilisation in the EUR/USD and AUD/USD rates at their lower levels, the NZD/USD looks set to remain in its established 0.7600 to 0.7900 trading range for some time yet.
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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