In a year laden with risky events, we expect the NZD to underperform the USD and AUD, but outperform the JPY, EUR and GBP.
The main topic of interest for fx markets this year is likely to be the evolution of US interest rates and the US dollar. Since the US election in November, the US dollar has outperformed almost all currencies (Chart 1), and the consensus view is that this is likely to continue for at least the next few months.
Chart 1 – Broad-based US dollar strength the main fx story
NZD/USD was volatile in 2016, eking a 10c range, although it ended the year only 2% higher than where it started. Momentum is currently negative and it has potential to probe lower into the 0.6700-0.6800 area during the next few months. Technically, the wedge-shaped decline since September is incomplete (Chart 2).
Chart 2 – NZD/USD lower multi-month
The main determinant of NZD/USD in 2017, as it is much of the time, will be the US dollar (Chart 3). A stronger US dollar (and therefore weaker NZD/USD) is very much a consensus view (tighter US monetary policy/looser fiscal policy mix should boost the USD), and that makes us slightly nervous. For example, the US fiscal impulse could disappoint, tighter financial conditions could slow growth, and a mercantilist trade agenda could include a weaker US dollar. However, our base case is that the Fed will need to hike twice in 2017 and twice in 2018 – consistent with market pricing – and the US dollar will strengthen.
Chart 3 – Strong US dollar hurting NZD/USD
Absent a strong US dollar, we would certainly be more bullish on the NZD/USD’s prospects. Taking into account commodity prices, interest rates and risk sentiment, our fair value model estimates it should currently be trading closer to 0.75 than 0.70 actual (Chart 4). That said, misvaluations have been larger in the past and persisted for long periods.
Chart 4 – NZD/USD trading below fair value
NZD/AUD ended 2016 little changed (+1% net over the year). During the second half whispers of parity were again heard in market circles but ultimately the 0.97-0.98 area held. We expect that area to remain a significant barrier during the year ahead.
Technically there’s a case for a move lower during the next few months, towards a “neckline” at 0.9280 (Chart 5).
Chart 5 – NZD/AUD lower multi-month
On a more fundamental note, the cross has failed to keep pace with declines in its main determinants (interest rates and commodity prices, Chart 6).
Chart 6 – NZD/AUD vs interest rates and commodities
Incorporating these determinants into a NZD/AUD fair value model, along with risk sentiment proxies, yields a valuation which is considerably below the actual traded level. Currently, the cross should be trading closer to 0.8900 than 0.9500 (Chart 7). This misvaluation is the largest since our model started in 2003.
One explanation for this misvaluation is that the AUD has been treated harshly by markets, our AUD/USD fair value model estimating the AUD is significantly cheap. The AUD’s identity as a freely floating risk proxy in a market concerned about central bank fuelled asset prices, Trump’s likely positions on trade, China, higher Fed and bond rates, European elections and Brexit at least partly explains why the AUD has been downtrodden.
Looking ahead, the AUD has scope to more fully price in the positive bulk commodities story which was most recently evidenced in the Dec trade data. A reduction in misvaluation and decline in NZD/AUD to 0.93 during the next few months is our base case.
Chart 7 – NZD/AUD is around 6c overvalued
In October NZD/JPY started to break out of its multi-month malaise, gaining 15% by December. Some consolidation here is warranted, which means the cross could slip further to the 78-80 area, but eventually we expect the 84 level to be retested.
Chart 8 – NZD/JPY higher eventually
Interest rates and risk sentiment have decent explanatory power for NZD/JPY. We expect NZ rates to outpace Japan’s. While the BoJ’s decision to replace a monthly volume target for its asset purchases with an outright interest rate objective may result in the central bank buying fewer securities, term interest rates are still expected to be held near zero indefinitely, leading to an widening NZ-JY rate differential.
Chart 9 – NZD/JPY vs main drivers
NZD/EUR spent 2016 inside a rising wedge-shaped range, gaining 5% over the year. One weight on the EUR was the ECB’s decision to extend its asset purchase program to at least December 2017 at a purchase pace of €60bn per month This was a longer extension than anticipated by markets, while Draghi also clearly emphasised that risks to growth and inflation are to the downside.
We expect NZD/EUR’s rise to extend further this year, a break above the 2016 high of 0.68 conceivable.
Chart 10 – NZD/EUR higher
Over the short run, NZD/EUR has a closer statistical relationship with interest rates than with commodities or risk sentiment (Chart 11). We expect NZ rates to outpace those in the Eurozone, since the ECB will need to contend with elections in Germany, France, Netherlands and probably Italy next year, as well as Italian banking system risks. The RBNZ, in contrast, is on hold with the next policy action (admittedly some way off) likely to be tightening given the NZ economy’s strong performance.
Chart 11 – NZD/EUR vs main drivers
NZD/GBP spent 2016 in bullish mode, gaining 22%, with most of that occurring after the Brexit referendum in June. In November it made a post-float record high of 0.61 (last seen in 1974 when both currencies were fixed), a level which could be exceeded this year.
Chart 12 – NZD/GBP higher
NZD/GBP has only weak relationships with the usual short-term determinants of exchange rates (Chart 13). Our outlook for this cross, then, is driven mostly by our expectations regarding the key UK risks event: Brexit. At the very least, until some form of Brexit is officially triggered, uncertainty will linger. And even in the aftermath, the economic consequences will take time to unfold. The hit to business and consumer sentiment and resultant negative impact on the UK economy will require further support from the BoE as well as a lower GBP exchange rate. GBP/USD should fall much faster than NZD/USD, resulting in a higher NZD/GBP.
Chart 13 – NZD/GBP vs main drivers
This content is reposted from Westpac. The original is here. It is here with permission.