Opinion: The Dow is driving the Kiwi dollar; watch those US corporate earnings results

Opinion: The Dow is driving the Kiwi dollar; watch those US corporate earnings results
Roger J KerrBy Roger J Kerr A resurging US stockmarket last week has put paid to any expectation that the upward momentum in the NZ dollar against the USD was running out of steam. The Kiwi jumped up to 0.6500 when better than anticipated profit results and outlook by chipmaker, Intel stimulated a major rally in the Dow Jones Index. Why there is such a close linkage and correlation of the NZD/USD exchange rate to the fortunes of the US sharemarket is certainly troublesome to comprehend for those not trading the foreign exchange markets everyday. For the last five years the Kiwi has tracked the Dow Jones Index up and down as the forex markets buy or sell NZ dollars depending on whether "risk aversion" by global investors is decreasing or increasing. The rationale (if it can be called that!) is that currency traders/investors will happily buy Kiwi dollars if they believe that investors are increasing their risk appetite i.e. when the US sharemarket is heading strongly upwards. These types of "cause and effect" relationships abound in currency markets as reasons to justify taking short-term speculative positions (long or short NZD's). While traders and speculators continue to make money out of buying Kiwi dollars when the Dow is rising, the correlation is perpetuated "“ a self-fulfilling prophecy. The correlations break down when something extraneous comes along that breaks the nexus and causes the speculators to lose money. The NZD/USD exchange rate correlation against the Dow Jones Index has held together rather tightly for the last five years, however the Kiwi's recent appreciation to 0.6500 from the mid-0.50's area has moved a lot higher than the US sharemarket recovery of recent months would suggest. correlation of DJI and NZD-USD exchange rate The Kiwi's gains to 0.6500 are in the main attributable to a weak generally USD, however the level of 0.6500 is considerably above where the two other main drivers would value the currency. Both the CRB commodity index and the US:NZ short-term interest rate differential point to a NZD/USD rate under 0.6000. Charting the US sharemarket correlation suggests a value of 0.5500 for the Kiwi. While the Kiwi appears out of synch with these key currency drivers and would be expected to correct downwards, it will require independent negative New Zealand news to shock the markets into re-rating the Kiwi lower. Not even a "negative watch" credit rating adjustment for the NZ sovereign rating from Fitch last week was sufficient to push the currency permanently down. There are two possible and potential local events over the coming period that could knock the Kiwi off its 0.6500 perch:- - If Fonterra was forced to lower their 2009/2010 milksolids payout forecast to dairy farmers to say $4.00/kg from the current $4.55/kg, the FX markets would sell the Kiwi down as our largest export industry would be unprofitable and the negative implications for the wider economy very material. The current $4.55/kg forecast is based on a 0.5900 exchange rate and international wholemilk powder prices have moved lower again. Maybe Fonterra should lower their forecast anyway, just to get the currency down and helping themselves! - RBNZ Governor, Alan Bollard has been talking the NZ currency lower, unfortunately the FX markets focused on his more optimistic comments of the NZ economy coming out of recession ahead of others. Whilst the NZ dollar remains above 0.6000, the export-led recovery will not happen. Perhaps Mr Bollard needs to follow up his words with action by surprising the markets and dropping the OCR to 2.00%. Such a change in the official interest rates is not justified from an inflation or monetary policy perspective, but it may be the only way the New Zealand economy can pull itself out of recession. The probability of an announcement by Fonterra is much higher than a rate cut by the RBNZ; however the NZ economy needs someone or something to break the investor "risk aversion" nexus of the NZ dollar to the US stockmarket. "”"”"”"”"”- * 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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