By Roger J Kerr
A constructive way of analysing and determining the likelihood of the NZ dollar appreciating or depreciating from its current price of 0.6500 to the US dollar, is to prioritise and score the probabilities of the key currency drivers moving up or down.
In this manner, those with foreign exchange rate risks may formulate risk management strategies based on hedging percentages.
Managing currency risk is not about correctly picking the finite direction of the exchange rate over the next three or six months, it is about having appropriate protection levels in place against adverse market movements with sufficient participation in favourable movements.
It is a matter of probability and degree of movement, not absolute right or wrong.
The three major drivers of the NZD/USD exchange rate direction at this time and their respective probabilities of moving higher or lower over coming months may be summarised as follows:
- Wholemilk Powder (WMP) prices
At the current record low market prices of USD1,500/MT the probability of stability or recovery upwards in the price starts to outweigh the chance of further reductions. The forward futures prices for WMP are USD2,100/MT for December 2015 delivery and USD2,600 for June 2016 delivery. The Global Dairy Trade auction this week on Tuesday night 18th of August may see the first signs of price stability for a good few months. Arguably WMP prices going below USAD1,500/MT is already priced-into the NZ dollar as the last GDT auction recorded a 10% fall and the NZD/USD exchange rate was not sold any lower. Assigned probabilities for WMP are 25% up, 50% stable and 25% down.
- New Zealand interest rates
The local moneymarkets are currently pricing in a 100% likelihood of another 0.25% cut in September and a 80% chance of a fourth 0.25% reduction in early 2016. That interest rate pricing is already built into the current NZD/USD exchange rate. If it transpires that the RBNZ does not decrease the OCR as much as the current pricing, the NZ dollar would start to recover upwards (and vice versa). Economic growth data and lead indicators would need to improve from here and move above current RBNZ forecasts for the RBNZ not to cut the OCR any further. The case for the RBNZ cutting interest rates by more than what the market is currently pricing seems a low probability. WMP prices would have to collapse further and inflation outcomes track well below forecasts. Assigned probabilities are 20% for the RBNZ not cutting as much as the market is pricing, 70% for RBNZ cuts as currently priced 10% for more cuts than priced
- US dollar movements
As expected, the US dollar has stabilised against the Euro over recent months around the $1.1000 area. Further US dollar appreciation to $1.0000 on the Federal Reserve increasing their interest rates by 0.50% over the next 12 months is not anticipated as the FX markets have already priced this US interest rate change into the current $1.1000 Euro exchange rate. If the Federal Reserve delayed the first 0.25% increase from the expected timing in September, the USD would weaken (NZD stronger). A delay seems unlikely as US economic data continues to print universally positive. Assigned probabilities are 10% for the Fed increasing interest rates more aggressively and the USD strengthens to $1.000, 50% the Fed increase in line with market pricing (stable USD) and 40% the Fed delay the first increase and the USD weakens.
Combining the probabilities results in a 28% chance of NZD recovery from here, 57% the NZD/USD rates remains in the mid 0.6000’s and only a 15% probability of further depreciation.
Current trading bank forecasts are unanimously in favour of the NZ dollar depreciating to below 0.6000. The above analysis gives equal weighting to the three drivers, the reality of the FX marketplace is that some determinants wane in importance and new/unknown factors emerge.
One such unexpected variable that emerged last week was the devaluation of the Chinese Renminbi by their central banks as they add to their monetary stimulus to ensure the 7% GDP growth target is achieved this year. Whilst Chinese devaluation is negative for commodity currencies in the short-term, medium term a Chinese economy that continues to expand at a rate above 7% is good news for the New Zealand economy.
Also good news for the NZ economy in the long-run is a signing of the Trans Pacific Partnership trade agreement.
Freer access for our export products (e.g. value added products like ice-cream into Japan) into larger markets is positive news for NZ living standards all round. Therefore it is difficult to understand the rationale for the current anti-TPP protests around the county.
The very same protesters say that New Zealand should diversify its exports away from agricultural commodities to value added consumer products. The TPP trade deal would allow that to happen !
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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