Lower is not better if it is volatile says Roger J Kerr. He is worried that currency markets have a habit of overshooting

By Roger J Kerr

The love affair that global investors and currency speculators have had with the NZ dollar over recent years has certainly turned sour over the last two months that this commentator has been overseas on holiday.

The overall currency value as measured by the TWI Index has depreciated 6.5% from 76.00 to 71.00 over that time.

The independent NZ dollar selling due to a combination of inter-related events that turned the sentiment negative and sent the NZD/USD rate well below the 0.7100/0.7200 level that I thought would have provided some support.

The slide in the NZD/USD rate to 0.6700 has on this occasion not been due to general USD strength on global FX markets (the USD Index has been stable around 96.00 over the period), however entirely due to specific and independent negative NZ factors, namely:

  • Plummeting dairy prices as the international supply/demand imbalance is taking longer than expected to rectify itself.
  • The surprise RBNZ’s decision to cut the OCR mainly due to the negative impact of lower dairy prices on the NZ economy.
  • Weaker than expected export trade and GDP growth data over the first quarter.
  • A weaker AUD as copper and other hard commodity prices tumbled when China cut their interest rates and the Chinese commodity carry trade/financing arrangements were unwound.
  • Weaker global sharemarkets (risk/volatility measures increasing) as a result of the Greece uncertainty and plunging Chinese sharemarkets.

The question for the FX markets from here is to what extent the NZD/USD rate at 0.6700 has already price-in a total of four OCR cuts to decrease the official interest rate to 2.50% and Wholemilk Powder (WMP) prices remaining at USD2,050/MT. In my opinion the 0.6700 rate has already fully priced such outcomes.

These two driving determinants of the NZD value are inter-related in that any recovery (unlikely in the immediate future) in WMP prices will reduce the probability of all four 0.25% interest rate cuts occurring. If WMP prices fall further, continuing NZD weakness to 0.6500 and potentially below would result. What is likely is that the substantially lower USD2,000/MT price for WMP will reduce the volume of product being supplied to the globally traded market as it is just not profitable for many producers to sell at that price level.

What has been interesting to observe from outside NZ over recent weeks is the seemingly unanimous chorus that an even lower exchange rate value is the best thing for our economy.

It is like wishing that your company share price, or enterprise value, would reduce further??

Most exporters will tell you that a generally stable and low volatile currency is more important to them than the absolute level. The Kiwi dollar’s 20 cent drop from 0.8800 over the last 12 months does not help the desire for lower volatility (currency hedging programmes/policies can deliver this). A depreciating or undervalued NZ dollar also entices our exporters to sell on price alone, which is never a recipe for successful long-term product market positioning and wealth creation. A currency that is too low potentially makes our exporters complacent and lazy in respect to product development and moving up the value chain.

What is encouraging is that the automatic shock-absorber to the economy that a floating (and lower) NZ dollar provides when our key export commodity prices fall continues to work well.

The NZ dollar has a history of over-shooting on both the topside and bottom side on its major realignment moves.

What is not yet clear to me is whether the bottom side overshoot on this occasion is 0.6600 or 0.6200.

Future movements in WMP dairy prices over coming months should provide that answer. 


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Daily exchange rates

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Roger J Kerr is a partner at PwC. 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