Currency markets pull their heads in over Greek restructure worries

By Mike Jones and Kymberly Martin

The NZD/USD spent most of last week trading choppily in a 0.7840-0.7990 range.

Nervousness about the outlook for global growth spurred widespread volatility across global asset markets last week. Wild swings in commodity prices and investors’ risk appetite kept the NZD trading in a choppy fashion.

Worries about Chinese growth momentum flared up following a surprise slowing in April industrial production. Speculation Greece will need to restructure its sovereign debt also did the rounds following S&P’s two notch Greek downgrade. Global stocks and commodity prices declined for a second straight week and our risk appetite index (which has a scale of 0-100%) slipped from 71% to around 67.5% by the end of the week.

Generalised uncertainty and rising risk aversion saw investors seek out the relative “safe-haven” of currencies like the USD and JPY. Given the renewed concern over the plight of Greece, the EUR tended to bear more of the brunt of the firmer USD. So while the NZD/USD lost some of its lustre last week, the NZD/EUR climbed to 3-month highs of nearly 0.5600.

Thursday’s Budget will no doubt confirm a large core deficit in the order of 8% of GDP. More important will be what the Government plans to do about it. While a cyclical GDP recovery will be presumed, most of the turnaround will depend on a “reprioritisation” of Government expenditure. In other words, brace for a tight one.

Wednesday morning’s Fonterra milk price auction stands out as the other important event of the week, particularly in the context of recent turbulence in global commodity markets.  

There is certainly the potential for a surprise from this week’s Budget and/or Fonterra’s milk auction to influence the NZD. However we suspect offshore trends in commodity prices and risk appetite will remain the bigger driver of the currency.

We’ve been highlighting for some time the fact recent NZD/USD gains have run ahead of “fair-value”. This remains the case with NZD/USD “fair-value” according to our short-term valuation model sitting in the 0.7300-0.7500 range. This only increases the downside vulnerability of the NZD/USD should current European sovereign debt ructions intensify and risk appetite and commodity prices fall further.

Majors

The USD strengthened against all of the major currencies on Friday. Over the week the USD index rose 1.2% to be up 4.2% from its 4 May lows.

Through the first part of Friday night the perky EUR/USD kept the USD heavy. March quarter Eurozone GDP figures inspired optimism about the strength of the European economies. GDP expanded 0.8%q/q (0.6% expected) with Germany (+1.5%q/q) and France (+1.0%q/q) leading the way. From around 1.4200 before the data, EUR/USD was soon heading north of 1.4300.

However it wasn’t long before sovereign debt jitters reared up again, taking a heavy toll on investors’ risk appetite and the EUR/USD. German newspaper Die Welt reported the EU and IMF are ready to agree on a restructuring of Greek debt, knocking the EUR from above 1.4300 to nearly 1.4100. Global stocks posted declines of 0.1-1.2% and the VIX index (a proxy for risk aversion based on S&P500 implied volatility) jumped from 16% to above 17%.

It seems a bout of USD position squaring was partly the cause of last week’s USD gains. According to CFTC data released on Friday the speculative community trimmed their net USD short position by 20% last week, mostly a 38% slashing of the large net long EUR position.

Looking ahead there is plenty of economic data and official rhetoric due this week that will help shape currency market sentiment. Tonight’s Eurozone CPI, US housing figures on Tuesday, Wednesday’s Bank of England minutes and a wealth of Fed speak (starting with Chairman Bernanke tonight) will all be important to watch in this regard.

Nevertheless the twists and turns of the European sovereign debt saga and its effects on the EUR and risk appetite will remain the most important currencies driver in the short-term. This is particularly so with the EU/IMF meeting kicking off tonight (finishing Tuesday evening).

Fixed Interest Markets

Last week saw little move in NZ interest rate markets after the dramatic declines in yields seen in the previous couple of weeks.

Bond markets appear to be consolidating at current levels. Friday’s DMO auction that saw solid demand at 2-2.5x bid-to-cover ratio, but nothing like the excess demand seen in previous weeks. Yields on 13s hover around 3.22% while 21’s yield sits around 5.24%, just a nudge lower than a week ago. It is worth remembering however that 21’s yield was around 5.79% just a month ago.

Swap markets have also been relatively quiet recently with 2-year swap rates down around 3bp to end the week around 3.33%. 10-year rates rose slightly to around 5.25%. The swap curve is therefore slightly steeper with the 10-year/2-year spread now around 192bp. The difference between 10-year bond yields and similarly dated swaps (EFP) is holding just above zero after being in negative territory for most of the past year.

On Friday US CPI for April came in line with expectation at 0.4%m/m, down from 0.5% in the previous month. CPI ex-food and energy also came in line with expectation at 0.2%. The recent pull-back in commodity prices (the CRB global index is down around 9% from an end of April peak of 371) may be helping to calm inflationary fears. US 10 year yields declined from around 3.22% to around 3.17% bouncing off familiar support levels around 3.13%.

Despite the recent fall in US yields, the more significant fall in NZ yields in recent weeks sees the NZ-US 10-year bond spread at around 2.06%, down from around 2.36% in mid April. It is difficult to see a meaningful further fall in NZ long yields in the absence of US long yields falling further. However US 10-year yields appear well supported around the 3.15% level.

After last week’s further downgrade to Greece’s sovereign debt rating by Moody’s and S&P, European sovereign debt issues will remain in focus in the week ahead.

See our interactive swap rates charts here and bond rate charts here.

Mike Jones and Kymberly Martin are part of the BNZ research team. 

All its research is available here.