By Roger J Kerr
Local and international financial markets appear to be lurching from one “event risk” to the next with the shemozzle they call Australian politics closely following the shock Brexit referendum result in the UK.
Volatility in foreign exchange markets lasted only a very short time following the surprise outcome of the Brexit vote on 23 June.
The Pound Sterling value plunged from $1.5000 to below $1.3300 against the USD immediately following the UK vote, however has stabilised over this last week with no follow through selling as they attempt to sort out an orderly EU exit in a difficult political vacuum. The NZ dollar raced up to 0.5400 against the Pound and has remained at that elevated level. Like the Japanese Yen, the NZ dollar is seen by some as a safe-haven currency in times of turmoil.
A very unsettling political vacuum would be something of an understatement to describe the outcome of the Australian general election last weekend.
The seeking of a fresh political mandate by PM Malcolm Turnbull with the double dissolution of the House and Senate and calling a general election has horribly back-fired on the Liberal Party leader.
The prospect of a minority Government with unreliable support from a rag-tag of Independent and Green MP’s hardly instils confidence at any political or economic level.
How the Australian financial and capital markets react to this self-perpetuated political mess remains to be seen (this column being written before the markets open on Monday 4 July).
Like the Brexit leave outcome, the markets did not see this coming and are not prepared in advance for the likely volatility.
Markets do not like uncertainty and the unknown in any form, thus selling of the Australian dollar by offshore players over coming days has to be expected.
Should Malcolm Turnbull be unable to form a Government in Australia this week after special and postal votes are counted, the FX markets will be reacting to a potential Labour minority government with the prospect of larger fiscal deficits and debt levels. Credit rating agencies will have Australia’s Federal and State finances under very close scrutiny over coming week/months, which cannot be positive for the Aussie dollar’s value.
The big question in the short-term for our NZ dollar currency market is to what degree the NZD/USD follows the AUD/USD rate down?
Over the past two months the NZ dollar has posted major gains against the AUD from 0.9100 on the cross-rate to 0.9650 following the cut to Australian interest rates by the RBA in early May and the failure of the RBNZ to reduce the OCR here when they have had the opportunity in late April and early June.
The end result of the changed stance by the RBNZ over the last three months from worry about the over-valued currency (cementing in super low inflation) to worry about the housing market bubble is a sharply higher Trade Weighted Index (TWI).
The TWI has spiralled 8% higher from 71.00 in January to 76.60 today because the RBNZ have not reduced the OCR further and thus 3% New Zealand interest rate yields are seen by all and sundry as very attractive in a world of 0% yield returns.
The NZ dollar is being bought to receive some yield return on the money invested. If the NZD/USD rate does not follow the expected weakening in the AUD, the NZD/AUD cross-rate and the TWI will increase even further. Above the 0.9600 level, the NZD/AUD cross rate has to be considered as the NZ dollar being extensively over-cooked compared to the NZ/Australian interest rate differential, which points to a cross-rate below 0.9000.
The historical correlation between the NZD/AUD exchange rate and the 90-day interest rate differential between the two currencies has been very strong and very reliable. History tells us that he NZD/AUD rate always follows the interest differential and this points to a much lower NZD/AUD exchange rate over coming months.
In the short-term it is difficult to see what the NZ specific negatives will be to drive the NZD/USD rate down further then the AUD/USD rate to deliver a lower NZD/AUD cross-rate.
Lower wholemilk powder prices at this week’s GDT auction may be one NZD negative.
The RBNZ do not review the OCR again until the 11 August Monetary Policy Statement.
The pressure will be mounting on the RBNZ to cut the OCR to reverse the currency appreciation. The much higher Kiwi dollar value means that the RBNZ are forced to reduce their inflation forecasts yet again, continuing the breach of the 1% to 3% required inflation band.
They are outside their mandate and cannot continue to say these are exceptional circumstances and the breach is acceptable.
If the financial stability of banks is being threatened by overvalued house prices and low mortgage interest rates, the RBNZ need to more rapidly implement further macro-prudential controls on bank lending to address that risk. By not cutting interest rates because to the housing market situation, the RBNZ are potentially causing greater damage to the economy as farmers and exporters suffer from the appreciating NZ dollar.
An inevitable realignment of NZ interest rates to the much lower levels in Australia and elsewhere suggests that the NZD/USD foray above 0.7000 will not be too long lasting and a return to the mid 0.6000’s (TWI back to 71.00) would be more consistent with our economic fundamentals.
Roger J Kerr contracts to PwC in the treasury advisory area. 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