By Roger J Kerr
The NZ dollar exchange rate against the USD is back above 0.8000 again as the USD continues to weaken on global foreign exchange markets. On all the previous occasions the Kiwi dollar has traded above 0.8000 it has been unable to hold on to the lofty levels and has for various reasons reversed rather quickly back down again. Will this occasion be any different?
For the NZD/USD rate to reverse out of its strong uptrend since 0.7150 in 17 March, two things have to change in global financial/commodity markets:
1. The USD currency value needs to strengthen in international FX markets, particularly against the Euro, which has made gains due to the recent European interest rate increases.
US economic data has been quite robust over recent months, particularly in the manufacturing/employment part of the economy. However, the crucial residential property and thus household sectors are still struggling.
The US Federal Reserve meets this week and the majority vote within the Fed stall favours a continuation of super loose monetary conditions. Whilst they are still printing dollars the USD currency value will remain under downward pressure. The mood within the Fed needs to shift to a position that the US economic recovery is running on its own stream and then the FX markets will start to price-in a greater probability of increasing US short-term interest rates.
When this happens the USD should start to recover against the EUR. The NZD/USD rate does follow the EUR/USD exchange rate and a return of the EUR/USD rate to $1.3000 from $1.4500 over coming months should see the Kiwi back down 10% as well to the low 0.7000’s. It will require more negative sovereign debt news out of Europe and a shift in current Fed thinking to cause the USD to strengthen in this way.
2. Commodity prices need to at least stabilise, if not weaken, which may take an increase in US interest rates
Global commodity prices have continued to make gains as strong Asian buying demand meets restricted supplies in many commodity groups. In many respects, the 30% increase in New Zealand’s agricultural commodity prices over the last 12 months justifies the much stronger NZD currency value; however the commodity prices need to keep rising for the currency gains to continue.
The growth/commodity currencies, the AUD, CAD and NZ, are always bought up by currency traders and speculators when hard and soft commodity prices increase in global markets. It was expected that the current tightening of monetary conditions in China (designed to slow growth/demand and restrict inflationary pressures) would reverse the uptrend in global commodity prices. To date this has not happened.
It seems that it might take actual increases in US short-term interest rates to take the gloss of rising commodity prices. US interest rates are unlikely to increases until early 2012; however FX and commodity markets are always looking forward and factoring in future economic and financial/investment market conditions.
Of course the two aforementioned global forces are inter-related in that the USD always weakens against major currencies when commodity prices increase (and vice-versa). All commodities are traded in USD’s and the USD exchange rate adjusts to keep stable buying and selling prices in major currency terms.
On the domestic front, the continuing ”front-running” bond issuance strategy by the NZ Government to borrow larger amounts early whilst the investor demand is strong is adding to the NZ dollar buying pressure. Asian investors are dominating the buying of NZ Government bonds over recent months and they do not tend to hedge the currency risk on their investment. The net result is buying of NZD’s to buy the NZD denominated bonds.
3. Credit Rating Downgrade?
These investors and the forex markets themselves have not yet started to build in the risk of a NZ sovereign credit rating downgrade by Standard & Poor’s. The probability of a downgrade has arguably increased from a 30% chance when we were placed on “negative outlook” a couple of months back, to nearer 50% chance today as the Christchurch earthquake reduces tax revenue income into the Government and increases Government spending/debt.
The Government’s budget on 18 May will need to satisfy Standard & Poor’s that economic policy initiatives contained therein will reduce future Government spending and thus budget deficits. Finance Minister Bill English has very little wriggle room in his budget to keep both Standard & Poor’s and the voting public happy. A credit rating downgrade would certainly reduce overseas demand of NZ Government bonds, thus the current font-running bond issuance exercise is smart (and prudent) risk management by the NZ Debt Management Office. If overseas buying demand for our bonds reduces after a credit rating change, the Kiwi dollar looses a major support.
* 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