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The “risk-off” sentiment that has pervaded global investment markets over recent days due to falling tech stocks in the US has caused a minor flight to safety/safe-haven of US Treasury Bonds. The 10-year US Bond yields have reduced from 2.75% to 2.62%, however our five to 10 year swap interest rate have not moved too much at all in response. Borrower’s “paying fixed rate” demand is outweighing investor “receiving fixed rate” demand in the local swap market. However, whilst our swap rates are not necessarily following US bond yields lower, the positioning in the market is such that I still expect our swap interest rates to increase when US bond yields succumb to higher US growth/inflation and move considerable higher above 3.00%.

The local focus is on the CPI inflation result on Wednesday 16th April followed by the RBNZ OCR review on 24th April. Consensus forecasts are for the March quarter’s inflation to have increased 0.5%. However, lower food prices and the higher than assumed NZ dollar currency value would suggest that the risk is that the actual results is more weighted to a probability of a +0.4% outcomes than a +0.60% or +0.7% result. The risks of future inflation increasing are still very real from higher construction costs, the perennial non-competitive parts of the economy and potential NZD weakness removing the price reduction offsets we have experienced in recent years.

The high NZ dollar value has made the RBNZ’s inflation policing job all too easy in recent years. Any complacency about inflation risks will be exposed if and when the NZ dollar depreciates due to tumbling milk powder prices/terms of trade index. Borrowers have to be aware that interest rate increases could be a lot sooner and more severe if the NZ dollar falls sharply. Whilst there seems to be a lot of confidence around that the NZ dollar will not suddenly plummet, the global foreign exchange market’s verdict on a small currency can be swift and draconian once the sentiment and confidence shifts from positive to negative.


Kiwi dollar diverging from critical lead-indicators

Two significant developments over recent weeks suggest that the over-extended high value of the NZD/USD rate at 0.8700 and overall TWI Index level (81.00) are very much on borrowed time. The FX markets have not yet really reacted by selling the NZ dollar down due to the dramatic changes in the two variables below, however given time it is inevitable that the exchange rate will follow these important lead-indicators lower:-

• Wholemilk Powder (WMP) prices have plummeted over the past month by 20% from their record highs of USD5,000/MT to USD4,000/MT at the last Fonterra/GDT auction two weeks ago. Historically there is a greater than 70% correlation between WMP and the NZD/USD exchange rate. The rest of the world sees our economy as one large dairy farm and the plunge in our key commodity price is not good news for our economy. In particular, if the exchange rate does not immediately follow WMP prices lower, the 2014 GDP growth forecast must be lowered.

• Global share investors have suddenly become very concerned at the over-valuation of technology and bio-tech stocks and the US NASDAQ stockmarket index has taken a hammering over recent days. Should this pending “tech wreck” snowball into a major sell-off on global equity markets, the NZ dollar will be sold as investors remove risk from the table. On previous “risk-off” mode periods for global investor sentiment the NZD and AUD have weakened on the forex markets as they are seen as “risk-on” currencies associated with increasing growth and rising commodity prices.

The upcoming profit reporting season for tech stocks is set to disappoint hedge fund type investors who are very quick to abandon any investment sector they all once rushed into. The rise and fall of emerging market stocks and currencies from 2009 to 2013 is a prime case in point. The IMF has recently warned about the dangers of volatile cross-border capital flows to individual economies and the NZ economy has had to contend with a high exchange rate over recent years due to being stable and attractive in a sometimes a very unattractive investment world elsewhere.
Should the 20% reduction on WMP prices be extended further as this Tuesday night’s (15th April) Fonterra/GDT auction, the penny may finally drop for hedge funds and investment banks who speculate in the NZ dollar.

The local dairy industry was expecting the record high WMP prices in January/February to last until the second half of 2014 and then slowly drift lower. Unfortunately, they have horribly mis-read the forces in globally traded milk powder. European and US sourced milk powder has suddenly turned up on the export traded market to increase supply. Additional supply in the main buying market of China has also come from their local dairy industry which has rebounded from foot and mouth supply problems last year. It is also reported that Chinese importer’s warehouses are full of milk powder. It appears that WMP prices are set to fall further.

For the meantime, however, the increase in New Zealand’s interest rates is causing something of resurgence in the “carry trade” buying of the currency. Past experience tells us that the carry-trade buying diminishes rather rapidly when the exchange rate heads south rather than the assumed north direction.

If the currency markets fail to recognise that the plunge in WMP prices will automatically drive New Zealand’s overall Terms of Trade Index (import/export prices) down 10% from 1380 to 1240 over coming months, thus considerably disturbing our current excellent economic fundamentals, then the RBNZ may have to take more of a centre stage position on this serious economic issue. If the divergence between the NZD/USD and WMP prices continues over the next 10 days to the RBNZ OCR review on 24 April, Governor Wheeler should consider a surprise “no change” to the OCR as the markets fully expect another 0.25% OCR increase. Such a decision by the RBNZ would be much more effective to pull the NZ dollar down than jawboning the currency lower or attempting direct FX market intervention.

It has not been in the RBNZ’s previous “modus operandi” to suddenly change their tact from the stated script. However, Governor Wheeler for the good of the economy may have to step out of the comfort zone and adopt the more courageous and confrontational style of the Reserve Bank of Australia in dealing with the financial markets i.e. surprise the markets by leaving the OCR unchanged on 24 April. On balance, it is unlikely the RBNZ will shift their plans within 10 days; therefore the full Monetary Policy Statement in early June is perhaps a more realistic time-frame when they may have some tough decisions to make if the NZ dollar/WMP price divergence continues. The RBNZ has been hoping that the USD itself would be strengthening at the time they have to return to OCR to more normal levels. For a host of reasons the USD has not been able to make gains against the major currencies to date, frustrating the RBNZ as the NZD/USD is at record post-float highs and they are increasing interest rates.

On top of falling WMP prices and global sharemarket indices, the third factor that should influence the NZD/USD rate lower over coming weeks/months is the ECB’s desire to stimulate the European economies further as they peer down the barrel of deflation and low growth. A Quantitative Easing type bond buying/printing of money in Europe would weaken the Euro against the USD from the current $1.3800 level to below $1.3000. A stronger USD against the Euro would negative for the NZD against the USD.