By Roger J Kerr
Almost completely lost in the economist and media commentary and opinion-pieces on the depreciation of the New Zealand dollar, dairy price plunge and so-called economic slowdown over the last two months, is the undeniable fact that a 0.6500 exchange rate is very positive news for New Zealand and its economic outlook.
Over recent years while the Kiwi dollar remained above 0.8000 against the USD on rising interest rates and high commodity prices, our manufacturing exporters quietly got on with re-shaping their business models, markets, costs and distribution channels to still make profit margins at the higher exchange rate.
Now they have experienced a windfall boost to their businesses with the lower currency value, albeit many still have legacy FX hedging entered at higher levels to work through over coming months first.
The significant increase in profitability this sector is experiencing will boost investment and jobs in the economy.
While Fonterra and the banks are reducing layers of middle management to cut costs and remain competitive, our manufacturing exporters are much more on the front foot.
The economic benefits will not be immediate, however looking into to 2016 the uplift will counter some of the negatives from lower dairy farming incomes and spending.
For this reason alone the doomsayers who are currently talking the economy down should be proved wrong again. The direct impact of uncertainties from Greece and China over recent weeks on the NZ economy has been close to zero. The rise and fall of the Chinese sharemarkets is not really having any impact on the overhang of wholemilk powder inventories in China that will keep dairy prices down for a few more months yet.
The collapse of dairy prices has played a big part in driving New Zealand’s overseas trade balance to the largest deficit since 2009. Consequently, the overall Balance of Payments Current Account deficit will widen further over coming quarters.
A number of local currency commentators are citing this development as a major reason why the NZD/USD rate will depreciate further to below 0.6000.
The historical correlation between our exchange rate value and the size of the structural Current Account deficit has however been non-existent since the dollar was free-floated in 1985. The lower currency value will boost exports and slow imports over the next 12 months and reverse the overseas trade deficit. It is hard to see offshore hedge funds and currency speculators deciding to sell the NZ dollar lower from 0.6500 because of the latest Balance of Payments trends.
The near term direction of the NZD/USD from the current level of 0.6600 will be determined by the Global Dairy Trade auction for wholemilk powder (WMP) on 4 August. The WMP futures are already pricing substantially lower to US$1,500/MT from US$1,800/MT at the last auction. An actual fall less than the futures pricing may see further NZ dollar buying on profit-taking, than further selling. Any hint at dairy prices forming a bottom over the next two months should be positive for the Kiwi dollar as the massive short-sold market positioning is unwound (i.e. NZD buying).
Over recent years the NZD/USD has maintained a reasonably close relationship with the VIX sharemarket volatility index as offshore players’ trade the currency based on the “risk-on” or “risk-off” mood of investment markets. When sharemarket volatility increases the Kiwi has generally weakened and recovered when volatility reduces. Over recent weeks since the Greece and China uncertainties have settled the VIX index has decreased. However, we have yet to see any corresponding NZ dollar strength. Dairy prices are dominating the Kiwi dollar FX market sentiment for the meantime, however once those dairy prices stabilise the forex market will return to looking at other drivers like the VIX index.
Many of the forecasters predicting a lower Kiwi dollar to below 0.6000 are still expecting the major determinant to be a stronger US dollar on global currency markets.
However, the situation appears to be that the EUR/USD rate at $1.1000 has already fully priced-in a lift of 0.50% in US short-term interest rates over the coming 12 months.
Therefore further substantial USD strength seems unlikely unless US interest rates are increased at a faster rate than what the markets currently expect.
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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