By Roger J Kerr
In every market (in particular financial, investment and commodity markets) a natural and inevitable response to very low prices is a “supply response”.
Sellers of any good or service will automatically reduce supply if the price is so low that they sell at a financial loss.
In respect to hard commodities, mines close as they are not economic to continue. Government subsidies and tax policies may distort the supply response, however ultimately prices recover if the demand is the same and there is less supply.
We have finally seen early signs of a supply response in three markets that have a direct impact on the value and directions of the NZ dollar, namely:-
- The collapse in crude oil prices to below US$30/barrel over recent months has led to a belated supply response with news that OPEC members are likely to meet to devise production constraints. Oil prices increased 11% in one day’s trading on Friday 12 February in reaction to the media reports.
- Investment and financial markets became very unsettled last week in response to reports that European banks were struggling with liquidity and structured bonds were tumbling in value in the marketplace. The response from global investment bank Deutsche Bank was to prove to the markets that they had both liquidity and available capital by buying back EUR5 billion of their own bonds. Removing the excess supply of paper from that particular bond market had an immediate impact on the price. Deutsche Bank’s share price increased 12% on the day as they sought to restore investor confidence. General investment market confidence should return over coming weeks.
- It is not so easy to suddenly turn off milk production or buy back excess supply to lift the price of milk powder on globally traded markets. There has been a supply response by US milk powder exporters as they cut back supply due to the current low prices. European exporters of milk powder continue to supply export markets as some subsidies and quotas still exist. However, one has to wonder for how much longer European suppliers will tolerate the low prices as their feed costs increase and the Euro appreciates against the US dollar.
The price results of the next GDT dairy auction on Wednesday morning 17th February will have an immediate and direct impact on the NZD/USD exchange rate.
The Kiwi dollar surprisingly did not depreciate on the 10% slide in wholemilk powder (“WMP”) prices at the last GDT auction on 3 February. WMP futures pricing indicates another 6% fall in the April delivery to below US$1,800/MT. In the absence of other influences, a sell down in the Kiwi dollar vale to 0.6500 from the current 0.6620 level due to the lower dairy prices would be expected.
Whilst the NZ dairy industry is struggling with the low prices, the rest of the economy continues to expand in reasonable buoyant trading conditions.
The overall economic health and performance relative to other economies does underpin the NZD currency value around 0.6300/0.6400.
Recent statements form the RBNZ indicate that they will not be automatically cutting interest rates again just because historical inflation is well below the 1.00% target bank minimum. The reduced likelihood of further OCR reductions also supports the Kiwi dollar in its well established and predictable trading range.
However, there is one scenario where the RBNZ would be justified in cutting the OCR and that is if the NZD appreciates to 0.7000 without any upward improvement in dairy prices. The RBNZ’s likely response to this scenario does provide a cap on the top of the NZD/USD trading range at 0.6800/0.6900.
The NZD/AUD cross-rate has recently spiked higher to 0.9400, however yet again there is no follow-through speculative buying interest at the top of the range. From here the speculative traders are more likely to sell the NZD down against the AUD back to the 0.9100 region. The ever dependable interest rate differential lead-indicator suggests a lower NZD/AUD cross-rate to 0.8900 over the medium term.
The weakness in the US dollar itself to $1.1300 against the Euro does not appear at all sustainable against the divergence in monetary policies on both sides of the Atlantic. A recovery in the EUR/USD rate to $1.0600 will also be factor to return the NZD/USD rate to 0.6400/0.6500 over coming weeks. In the medium to longer term a relatively strong NZ economy and eventual recovery in dairy prices auger well for the Kiwi dollar closer to 0.7000 than 0.6000.
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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