Credit downgrade avoided, however the Kiwi dollar is still toppy

By Roger J Kerr

The New Zealand Government forecasting themselves to return to budget surpluses within three years appears to have done enough to convince credit rating agency Standard & Poors that a downgrade is not warranted at this juncture.

The NZD/USD exchange has therefore avoided a sell-off, in fact the financial markets have provided a thumbs-up to the budget statement with the NZD up a touch, bond yields lower and the NZ sharemarket also rising.

In the short term the Kiwi dollar bounce back to 0.7950 from 0.7800 does not look to be too sustainable with the USD currency stronger against the Euro, weaker commodity prices and the Dow Jones Index also correcting downwards.

The Government’s revenue and expenditure forecasts over coming years culminating in a return to budget surpluses by 2014/2015 are based on 4% GDP growth in the economy next year.

The high export commodity prices support such an expansion in economic activity over coming years; however we will need to see stronger consumer spending coming off the higher rural incomes than what has been evident to date.

The super high export commodity prices do justify a higher NZ currency value on economic fundamental grounds.

Higher export prices mean stronger GDP growth, which leads to elevated inflation risks and thus tighter monetary policy which always results in higher interest rates and a higher currency level.

The unusual thing about the current situation in New Zealand is that interest rates are at artificially low levels after the GFC and any increase over the next 12 months would only take them back equal to where Australian interest rates are already sitting at 5.00%.

In the past, the NZD/USD toying with levels above 80 cents has only come about due to higher NZ interest rates compared to the rest of the world. We are up here again for other reasons this time, namely a strong AUD (weak USD), high commodity prices, reinsurance capital inflows and foreign investment inflows into NZ Government bonds. A forecast return of the NZD/USD exchange rate to the low 0.7000’s can only come about if these positive forces lessen in intensity or reverse.

There are positive signs that global foreign exchange markets have given away buying the Euro in favour of the USD.

The European sovereign debt situation goes from bad to worse and the likelihood of the European Central Bank increasing their interest rate again anytime soon appears very remote. The EUR/USD exchange rate has reversed from Euro highs of $1.48 to $1.41 over this last week and a return into the $1.30’s appears more likely as US economic data outperforms European on all fronts. Even though recent US economic indicators have hit something of a soft patch in recent weeks, the outlook for the US economy is far more positive than Europe. The USD currency value moves inversely to global commodity prices and the gloss has certainly come off the constant commodity price increases over this last month.

A sizeable correction downwards in global commodity prices would hurt the AUD, and the Kiwi continues to follow the AUD in the absence of any other outweighing local factors.

Outside the booming mining and resources sector in Australia, the high AUD exchange rate against the USD at $1.0650 is badly damaging their other export industries. Recent jobs and retail data in Australia really demonstrated the divide of Australia into a two-speed economy, the strong activity and money flowing in the resource-rich states of WA and Queensland, however much tougher times in the mortgage belts in NSW and Victoria.

There are sign of some cracks in the extreme optimism in Australia about Chinese demand ensuring their high growth rates continue. The tighter monetary conditions from the PBOC (to control China’s inflation which is above 5.00%) does seem to be finally working to pull the strong demand back somewhat. The Chinese do not have a free-floating exchange rate to assist the process of controlling inflation, thus a tightening of monetary policy takes longer when it is solely dependent on controlling bank credit and the cost of that credit.

A stronger USD and weaker AUD in the short term should ensure that the Kiwi fails to trade above the 80 cent level. A break below 0.7750 may well cause further selling from speculators who have been long the NZD over recent months.

The Reserve Bank of NZ’s monetary policy statement on 9 June will be the next focus for the local financial markets. Based on their past track-record of not realising that the economy is growing until retail and housing are moving up, they are more likely to stick to a dovish tone in this statement.

By September/October it will dawn on the RBNZ that 4% expansion in 2012 will bring some inflation risks and their dovish outlook will be abruptly reviewed. Therefore a lower NZD/USD rate over coming months due to a stronger USD may well be halted later in late 2011/early 2012 as our short-term interest rates are increased by the RBNZ.

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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