Roger J Kerr says the Brexit reactions have caused further over-valuation of the NZ dollar

By Roger J Kerr

Global financial and investment markets got the Brexit outcome wrong, the London bookies also got it horribly wrong, international economic institutions such as the OECD and the IMF called it wrong as well, as did the Conservative and Labour political parties in the UK.

Therefore, the consequences and implications of the UK referendum vote to leave the EU will be extreme uncertainty and volatility for an indeterminable period.

Only Federal Reserve head-honcho Janet Yellen called the Brexit correctly, she cited potential financial market volatility following the Brexit vote as a reason not to raise US short-term interest rates ahead of the 23 June referendum. Excellent pre-emptive risk management from Janet, which makes the RBNZ decision on 9 June not to cut the OCR even more of a monetary policy mistake following the RBA’s cut in May and the neutralising of the RBNZ cut in March by USD weakness.

Whilst (thankfully) the NZ economy is no longer reliant on the UK (our exports to them are less than 5% of total exports) we will experience the backlash in terms of further currency and sharemarket volatility as the market reactions play out over coming months.

One consequence already highlighted by local commentators is the likely increase in bank borrowing margins on international debt markets. Banking stocks were hit hard across Europe on Friday and the general “risk-off” sentiment in investment markets is likely to push up credit spreads for bank debt securities issued and traded in global markets.

Additional pressure will now be placed on the RBNZ to cut the OCR on 11 August to compensate the likely increase in bank credit/funding margins and to ensure that mortgage interest rates do not increase at this highly sensitive time for the over-heated residential property market.

As was always going to be the case, it was a wild roller-coaster ride for the Kiwi dollar once the polling results started to hit the newswires during Friday.

The Kiwi spiraled to a high of 0.7300 early on Friday when the initial poll results indicated a likely “remain” outcome (following GBP gains against the USD to $1.5000), only to be slammed down hard with the Pound when the results swung the other way.

The NZD/USD rate traded to a low of 0.6985, however recovered somewhat towards the end of the day to 0.7100. Further weakness in the Pound from the current $1.3450 and the Euro from $1.1050 against the USD seem likely over coming days and weeks as Europe and the UK markets are not places all types of investors will want to be.

Global sharemarkets tumbled between 3% and 7% across the world on Friday and as the UK and European political/economic turmoil and uncertainty rolls on, further decreases seem likely as investors adopt more cautious portfolio management policies.

The expected weakness of the major currencies (except the Japanese Yen) against the USD stemming from the Brexit vote should see the NZD/USD pull back to below 0.7000 over coming days.

However, with the TWI at 76.00 the NZ dollar remains over-valued against the major economic fundamental of dairy commodity prices which are really struggling to recover off their low price levels.

If they are consistent with the application of monetary policy, the RBNZ should be reacting to the currency being so out of whack with our economic fundamentals and taking measures to force the NZ dollar down. Whilst the RBNZ argue strongly that they cannot influence NZ dollar currency movements on the international stage, the evidence is to the contrary with their own OCR decisions over the last seven months generally forcing the NZ dollar higher.

Local exporters selling into the UK in Pounds Sterling had ample opportunity to place protective hedging a few weeks back in the 0.4500/0.4600 region. As the FX risk that was hedged against has mostly happened there is a fair argument for these exporters to be now reducing hedge percentages at the current spot rate of 0.5270, or at the very least replacing heavily “in-the-money” NZD/GBP forward exchange contracts with purchased NZD call options as the method of hedging. 

A potential longer-term adverse consequence for the New Zealand economy from the UK leaving the European market is that cross-border trade protectionism gains further momentum around the world. The international trade policies of the two candidates (Trump and Clinton) for the US Presidency are also towards protectionism of local jobs against those nasty foreign imports.

As an economy totally dependent on export market access and free trade agreements it is not good news for us. Following the machinations of the GFC seven years ago there has been a strong wave against globalisation and that trend has manifested itself in the UK vote. The ratifying of the TPPA by the US now appears nigh impossible and is a negative for the NZ economy and currency value.

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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

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