Opinion: AUD and EUR gains against the USD are overdone

By Roger J Kerr

The probability of the NZD/USD exchange rate returning to the 0.6000’s over coming weeks and months has reduced as the USD itself is sold heavily in international currency markets.

The NZD is weaker against the AUD and EUR on the cross-rate as it failed to follow the full extent of the AUD and EUR gains against the beleaguered USD currency.

Unfortunately for local exporters in USD without appropriate hedging in place against a prolonged period in the 0.7000’s, the high anticipation of further quantitative monetary policy easing in the US has undermined the USD’s value in the foreign exchange markets. There is no guarantee that the US Fed Reserve will increase their monetary stimulus from current measures in place when they meet in early November.

However, the markets are convinced and speculating that the weak US economic numbers and the weak recovery will force the Fed into further easing.

Effectively the Federal Reserve buys US Government Treasury Bonds out of the market and in doing so pumps money into the system. It seems many other countries (including Japan) are determined to also loosen monetary conditions further to help their economies recover. These economic policy changes also work to weaken their currencies and thus help their export industries and thus employment growth.

However, not everyone in the world can have a weaker currency as exchange rates are relative prices between economies.

The Australian dollar with its stronger economy, higher interest rates and rising commodity prices has been the big beneficiary of these monetary policy shifts in other economies. The NZD has been caught in the turbulent backwash of this AUD appreciation and dragged up to values that are clearly not justified by our own economic fundamentals.

The USD has weakened sharply in global FX markets from $1.30 to $1.40 over recent weeks as the markets speculate on the size of the second round of quantitative easing (“QE2”).

Given that foreign exchange markets are always pricing in the future well in advance, there is a reasonable chance that the USD weakness has gone too far if the US Federal Reserve do not pump as much money into the economy as what the markets are currently thinking. Similar to the rise in price of the AUD and commodity prices over recent times, the USD selling may be overdone and a recoil back to $1.30 may well be the result if the Fed package is not as large and US economic numbers continue to improve.

Recent ISM Index indicators (supply managers intentions) for the services sector were very positive and 80% of the jobs in the US are in services.

USD direction from here will be highly dependent on the strength of US economic indicators and whether they point to a stronger recovery than what the FX and interest rate markets are currently pricing.

The US sharemarket continues to be far more optimistic about the US economic recovery with the Dow Jones Index moving above the 11,000 mark. Latest employment figures in the US for the month of September recorded a decrease of 95,000 jobs; however 75,000 of those were in local government with private sector new hiring actually increasing.

The US economy has a major blockage to recovery as labour market mobility is being impaired by 25% of homeowners being under water on their houses with the mortgage debt greater than the house value. As a consequence, the workers cannot move location to where the new jobs are. It is debatable whether just lower mortgage interest rates will rectify this problem, or whether the Obama Government needs to step in with fiscal policy measures to unblock the system.

While to some eyes, the NZD/USD exchange rate does not correctly reflect the situation locally with weaker GDP numbers and interest rates staying lower for longer, the reality is that the USD itself has lost value as supply of the currency exceeds demand. The NZD/USD rate above 0.7500 represents USD weakness, not individual NZD strength.

There is no case of the RBNZ to intervene in the FX markets to sell the NZD as the overall value is not extremely over-valued, nor are the markets dysfunctional in any way.  In some respects the very high NZ commodity prices and record high terms of trade at this time support a stronger NZD value.

The European exporters (German in particular) will now be very unhappy that the Euro has appreciated and they will be exerting pressure on their policy makers to also loosen monetary policy.

Europe still has the potential to produce sovereign debt shocks similar to what was observed back in May which forced major Euro currency selling (and NZD selling to 0.6600). The fiscal and debt situation in Ireland is bordering on Greek-like proportions; however this deterioration has been overshadowed on the screen headlines by the QE2 speculation in the US. It would not be surprising to see negative European news reverse the EUR/USD exchange rate from $1.4000 as the international forex market focus shifts back to Europe.

The bad news must be fully priced into the weaker USD and all the good news for Australia must be fully-priced into the AUD at 0.9900.

The AUD has appreciated in a straight line from 0.8200 to nearly parity 1.0000 to the USD; it is long overdue for a downward correction as no currency continues such gains without major profit-taking at some point. Such major corrections in the AUD and EUR are expected and thus should limit further NZD gains and pull the rate back to 0.7000.

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 * 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