Roger J Kerr says markets pricing in all expected news, suggesting that they see no more significant downside from dairy

By Roger J Kerr

Price action in the NZ dollar foreign exchange market over this last week has been very instructive as to current market conditions and the likely future direction.

How much more bad economic news can the Kiwi dollar absorb and still not be sold lower is the question that springs to mind?

Despite wholemilk powder prices plunging to levels lower than even the bearish futures market had anticipated and Fonterra slashing their dairy payout forecast to $3.85/kg milksolids, the NZD/USD exchange rate ended the week above 0.6600, higher than where it started the week. The failure of the NZ dollar to depreciate on all this bad news just confirms how much the FX markets had already built in such outcomes beforehand.

It can be of no great surprise that the currency markets price-in the future so heavily all the time. The very nature of FX markets means that all that is known and anticipated today is built into today’s FX market rates.

The exchange rate only normally reacts violently with large price adjustments when the news is a surprise and totally unexpected. Buyers and sellers of the currency hurriedly adjust their positions/hedging strategy in such circumstances.

My reading and interpretation of the NZ dollar movements over the last four weeks (as opined in this column) is that the depreciation from 0.7500 to 0.6500 was a reaction to plummeting dairy prices. However, all that bad news for the NZ economy was already priced-in to the exchange rate at 0.6500 and fresh new NZD selling was waning in intensity and volume as a result.

While some economic/currency forecasters are still banging on about the fall in the Terms of Trade Index and Balance of Payments Current A/c deficit as new factors that will send the NZ dollar lower to below 0.6000, the FX market see this as stale news and are consequently not pricing the currency lower at this time.

It is a simple argument to state that if the NZ dollar was going to be sold lower due to all the negative economic news over the last two months, it would have already depreciated to 0.6000.

The fact that it has stabilised around 0.6500/0.6600 for a good few weeks now tells us that the sellers are exhausted and short NZD position holders are starting to unwind (i.e. buy back their Kiwi dollars) as the downtrend runs out of steam.

It may still be too early to call the ultimate bottom in the NZD/USD exchange rate as there are other influencing and important variables outside of dairy prices that are less certain as to outlook. While there can be some confidence that dairy prices cannot go much lower and the dairy demand/supply equation will re-balance and cause a recovery in prices within a few months, there is still much debate as to whether the recent monetary and fiscal stimulus packages in China will be sufficient to stabilise and lift metal and mining prices that are so crucial to the Australian dollar’s value.

The Reserve Bank of Australia’s moderation in wording last week in respect to the AUD currency is encouraging to the view that the AUD may have depreciated enough.

Globally we are seeing supply side responses to very low metal and mining commodity prices (aluminium smelters and coal mines closing) and the same responses can be expected from US and European milk powder suppliers. One of the five or six variables that caused the perfect storm for plunging wholemilk powder prices was low grain feed prices/costs in the US and Euroland allowing those milk producers to accept a lower selling price.

More recent price movement back upwards in grain (in Europe) suggests that the future supply and inventory volumes are less than expected. Wholemilk powder prices should eventually follow as the chart below against Maize futures (in Euro’s) prices shows.


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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