Reversal in commodity prices leaves the Kiwi vulnerable

By Roger J Kerr

The international and domestic buying forces that propelled the NZD/USD exchange rate to highs of 0.8100 last week suddenly seem to have lost their impetus and the Kiwi is looking more vulnerable to a sizeable correction down.

Risk aversion in global commodity and sharemarkets has suddenly increased and the reinsurance related capital inflows into New Zealand have slowed down.

The direction and sentiment in global commodity markets has reversed sharply in recent days as investors start to worry about world economic growth.

China has been the powerhouse behind the global growth story over recent months and commodity and equity markets have zoomed upwards in response.

The dip in prices immediately after the Japanese earthquake in mid-March provided the buyers with the opportunity to add to their long positions.

However the mood and direction abruptly reversed last week with silver and oil prices leading the commodity prices lower.

The markets have fresh concerns about the Chinese growth rate with higher inflation outcomes recently in both China and India reminding the markets that their monetary authorities are going to continue to tighten policy.

Unsurprisingly, the Australian dollar has been hit hard with the fall in commodity prices, reversing from highs of $1.0950 against the USD to $1.0700. Weaker than anticipated Australian retail data added to the AUD selling.

The Kiwi dollar followed the AUD down, dropping from 0.8100 to lows of 0.7820.

The Chinese have raised interest rates four times since last November (0.25% each time) and can be expected to carry on with the tighter policy as they have not yet got domestic inflationary pressures under control. US Treasury Secretary Timothy Geithner will again request the Chinese to raise their interest rates further and allow the Yuan currency value to appreciate faster to redress global financial imbalances. Allowing foreign investors to buy Yuan securities more easily would be one way to speed up the strengthening of the Yuan currency value.

Global commodity markets have been moving up strongly over recent months due to supply constraints in many markets and the relentless Asian demand. The investment and speculative element in the commodities markets may be reassessing their strategies as the Asian growth/demand equation is perhaps not as strong as they were factoring in. While the long-term trend line for commodities prices remains upwards, many see the need for a major correction downwards in prices to burn-off the speculative long-position holders.

That correction may have just started.

The USD currency value against the major currencies moves inversely to commodities prices. The USD has recovered from $1.4800 against the Euro to $1.4300 at the time of writing.

US economic data continues to improve, however the negative US fiscal position and the continuation of the monetary stimulus from the Federal Reserve has weighed the USD currency value down in recent months.

However, the USD weakness against the Euro to $1.4800 was hard to fathom against the backdrop of the deteriorating sovereign debt situation in Greece and the Europeans struggling to agree on ways to fix the problem.

The ECB having increased their interest rates once from 1.00% to 1.25%, as expected, seem a little reluctant to rush into a second or third increase.

The overall value of the US dollar as measured by the USD Index has done a U-turn from lows of 71 to rise to 75.

A stronger USD on the world stage was always a pre-requisite for a lower NZD/USD rate.

It looks like the USD can now recover further as US economic data out-performs European economic progress. Measures of speculative short-sold USD positions in the foreign exchange markets prior to the reversal in the commodity markets last week pointed towards an over-extended situation. The recovery of the USD cannot be surprising as the reasons for the heavy selling over recent weeks were never too convincing.

Locally the FX market’s focus will on the Government’s budget statement on May 19th. If the Government does not cut its cloth to fit lower tax revenue inflows, Standard & Poors will deliver their displeasure at the deficit/debt track and downgrade the AAA credit rating. That probability sits tantalisingly at 50/50 at this point. The Kiwi dollar could be expected to fall two or three cents on its own if S & P downgrade. The Government will be working hard to avoid that outcome; therefore close market scrutiny of the budget and how S & P react to it can be expected.

A return of the EUR/USD exchange rate to the mid $1.30’s seems much more likely now and this will deliver a NZD/USD rate below 0.7500 over coming weeks.

How global investors see commodity prices and the commodity/growth currencies after that will determine whether the Kiwi dollar is above or below the 0.7500 level through the winter months.