fxmatters

The danger is we see what we want to see. That particularly appears to be the case at present. The NZD/USD remains entwined with global share markets and global risk trades in general. To unravel the mystery of where the NZD/USD goes next thus requires trawling through global forces. What you find amongst the various commentators are strong reasons why, say, the US share market will continue higher and others with strong reasons why it will fall. Unfortunately the evidence in support of each case is selective, typical of the confirmation bias we often display; we tend to notice information in support of our view and ignore the opposite.

The reality is the share market and the NZD/USD could go either way near-term. The rush into high-beta US stocks appears to be over but that still leaves the global output and earnings momentum to push share prices higher. Likewise the slow US commitment to exit strategies favours more upside. Then there is the bias towards higher share prices in December to take into account (S&P500 up 16 of 20 years).

But exit strategies will become more prominent. The global fiscal and monetary tightening will temper enthusiasm for risk – and hence the NZ dollar. Exchange rate choppiness is likely to result.

For now, hedging against a higher NZD/USD remains prudent. But also factor into any strategy the strong likelihood of a lower NZD/USD within the next six months.

The mixed nature of forces will probably also show in different directions for cross-rates. It is time to start thinking about the possibility of a weaker NZD/GBP but a stronger NZD/AUD.

The global unwind of the policy stimulus is underway. Japan signaled an end to their (modest) quantitative easing last week and Norway raised their interest rates. We get to learn where US, Eurozone and UK central banks are at this week, and just how aggressive the RBA intends to be. A 0.25% rate hike by the RBA is likely but the others are more likely to forewarn of tightening rather than act now.

Markets have already signaled their unease with the stimulus unwind, the S&P500 down 4% last week being noteworthy. No doubt there will remain some too-ing and fro-ing as people balance the conflicting forces of economic recovery and stimulus removal but it does appear we have moved beyond the goldilocks period. The new stage need not necessarily bring a downward bias to share prices and the NZD but it is likely to involve more downward moves than has been apparent for several months.

The traditional carry trade – the NZD/JPY and AUD/JPY – has kicked in again in the last couple of weeks, in line with another surge in global share prices and the recent RBA tightening. Even NZ news added to the pressure with inflation running faster than expected (but not high enough to concern the RBNZ).

In simple terms the driving force appears to be the huge US stimulus. Historically money creation on this scale has created inflation. In recent decades the inflation pressure has tended to come through in asset prices. There in lies the quandary. The global authorities know that facilitating the asset bubbles of earlier years was a mistake, so surely they will respond this time sooner i.e. tighten monetary policy.

Some are doing this already e.g. the RBA. Others such as the BOE are hinting that they are coming round to this thinking. Comments from US Fed Chairman Bernanke will be listened to closely this week.

In the meantime the global good-news story will continue, strong Chinese growth likely to be reported this week and probably higher than expected Australian inflation next week judging by the NZ out-turn.

This all adds to short-term upward pressure on the NZD (except against the AUD and CAD, and maybe excepting the GBP now) but the risk of a sharp turnaround remains.

There have been some atypical movements in currency markets in the last week or so but at the end of the day the global recovery story continues, share prices are still pushing higher and the central banks around the world are loathe to act, suggesting the current upward NZD/USD momentum is not over yet.

There have been murmurs of disquiet with a low USD, and hence high EUR and JPY as well as high NZD, but there appears no concrete action imminent.

Meanwhile stronger NZ economic statistics – including probably business confidence released Wednesday – and talk of a near-term RBA tightening suggest the local currencies remain to the fore of any rally against a weak USD.

The NZD remains caught up in global forces. Last week the NZD generally weakened, falling against 30 of 38 monitored currencies but it was the gain against the weakening USD (and GBP) that received most attention. Over 4 weeks the NZD has appreciated against 34 of these currencies with one of the exceptions being the AUD. In other words, the RBNZ has not managed to disentangle the NZD from the weak USD on the one hand and the strong AUD on the other. There is the possibility that the release of NZ June quarter GDP Thursday (see Calendar) may shake the NZD free a little but more likely the fate of the NZD will rest with the major global trends.

Here the key tension is mounting evidence of global improvement and a reticence by central banks to respond for fear of derailing the nascent recovery. This is creating an abundance of US dollars and a goldilocks period for risky assets, especially when priced in USD. This period cannot last and the question is when the (relatively) little bubble is pricked. Ten years ago the answer was more likely later rather than sooner, the attitude being any remaining problems can be patched up afterwards. The recent experience of the financial crisis suggests central bankers should not allow bubble-like conditions to persist. Already there is tightening occurring outside the largest economies Bloomberg.

One example of the imbalances that the current policy settings cause is the Chinese yuan. It could be argued that a weaker USD is appropriate given global conditions but the USD is not just the USD – it is also the Chinese yuan (and the Hong Kong dollar) as the yuan is very closely linked to the USD at present. The end result is the EUR/CNY has now moved above the long-run average and there will be increasing calls within Europe for either a lower EUR or a higher CNY.

It is unlikely that the meeting of G20 leaders Thursday/Friday will provide a reaction plan, nor the US Fed meeting Wednesday (Thur 6:15am NZ time). But market players will increasingly focus on exit strategies (i.e. tighter monetary policy) in the next few weeks.

In terms of the NZD/USD, the momentum remains upward but the risk of a sharp turnaround is high.

Any post-MPS NZD selling was brief and more than offset by subsequent buying. In fact the NZD was one of the strongest currencies in the world last week (slightly behind the Russian ruble), posting the ninth consecutive weekly NZD/USD gain. It is apparent that the RBNZ are reluctant to respond to the stronger NZD, conceding they believe there is little they can do to influence the NZD – the result was the NZD/AUD rising 1.5% over the rest of the week.

However, the NZD/AUD remains within the upper half of an approximate 77-83c range. It is likely to remain within this range, including moving below 80c once market participants return to focusing on the probable gap between any RBA and RBNZ tightening (i.e. the RBA moving much sooner than the RBNZ).

Meanwhile the NZD/USD strength rests on a weak USD and strong share markets. There are global forces that could reverse both or each of these trends quickly. A bias towards selling the NZD at these levels appears appropriate but that is not to say the NZD/USD could not rise further in the short-term.

Movements in financial markets went against the usual patterns last week – AUD, GBP, NZD up but so too the JPY, all happening while share and oil prices declined. Significantly another wave of Chinese share market weakness failed to spark wider large-scale selling.

There are many questions about sustainability of current share prices (and an upward trend) but global economic news keeps showing up evidence of improvement. Locally the signs of improvement for August include NZ housing activity again up judging by Barfoot’s Auckland sales, likewise dairy prices, while retail sales failed to kick ahead but are improved on first half 2009 judging by Paymark electronic transactions.

Policy makers are taking a cautious approach to the global green shoots, generally adopting a no-tightening-soon approach. Significantly the RBA passed up the opportunity last week to warn of tightening ahead, although their comments were non-committal. Over the weekend, the G20 said “fiscal and monetary policy would stay expansionary as long as needed to ensure recovery”. The danger with this approach is that it sets up a greater knee-jerk reaction some months ahead – the eventual tightening will remain a market focus.

In the meantime, the Reserve Bank of New Zealand are likely to take this offshore lead by central banks and, consistent with their own earlier comments, play down the likelihood of near-term interest rate hikes when presenting the Monetary Policy Statement Thursday 9am. They may even go so far as to drop the cash rate by 0.25% to 2.25% p.a.

These present mixed forces for currency markets: the delay to the inevitable global tightening and the current growth momentum imply a rising NZD; the prospect of a dovish RBNZ and current nervousness about global share prices imply ample downside risks as well. A prudent approach would be to put more weight on the RBNZ this week and sell NZD ahead of Thursday.

The currency, and financial markets generally, are largely in a holding pattern at present – the weakening GBP an exception – in part due to a lull in information releases, in part due to Northern hemisphere holidays and in part due to markets having reached a natural point of inflection. New information is probably required to shift sentiment strongly, one way or other. The US S&P 500 share price index is now 54% above its 6-Mar low. This is about where the rebound rallies ended for Italy and France in the 1960s, the US, Switzerland and Europe in the 1970s and Japan in the 1990s. There were post-crash rebounds at other times that have gone further but we are in the zone where the recovery glow has tended to wane (see Morgan Stanley on the history of bear markets). Meanwhile we also remain within the time of year most prone to share market falls and we have insiders selling while the general public are buying. And to cap it off, we know that governments will have to tighten monetary and fiscal policy at some stage over the next couple of years (the Chinese have started already, contributing to a 3.4% share market decline last week). This makes for nervous markets, and most likely volatility.

From a momentum perspective, the near-term bias is likely to be upwards, there being little to indicate that the ‘good news’ is about to stop. For the NZD, upward pressure is also likely to come from an RBA approaching the time of its first tightening (don’t discount the possibility of a surprise rate hike Tuesday – the Australian cash rate is at emergency levels no longer required and it is now 5 months since their last easing, the same gap waited back in 2002 before the first-in-the-cycle rate hike).

From a value perspective, current levels in the share markets and NZD appear over-priced relative to the risks ahead.

In sum, the NZD/USD at 70c remains a strong possibility. But that need not prevent the NZD/USD again reaching 60c before Xmas as well.

The goldilocks period continues for the global financial markets – the news at the margin is largely positive (the level of activity is not!) while interest rates are very low – and hence up go global share prices, the price of oil and along with them the NZD, including the NZD/GBP passing the same peak reached in 2005 and 2008 (but not the NZD/CAD). There is one major challenge to this scenario this week – the US government issuing another massive round of debt Tuesday, Wednesday and Thursday – but the lack of other major scheduled financial news suggests the momentum carries the NZD generally higher in the next few days, and maybe weeks. However it still remains difficult to see the NZD/USD, for instance, remaining above 70c over a period of months.

Background articles of interest …

1) Investor confidence is now high according to the Merrill Lynch monthly survey of global fund managers, the index reaching its highest level since Nov-03 – a warning to all contrarians (and, yes, the S&P 500 did drop in the first half of 2004, by 5%).

2) The challenge ahead: removing the massive US stimulus in place without derailing the economy, and while holding onto your job Yahoo

3) Of a similar theme, former Morgan Stanley Analyst Andy Xie believes we are amidst a pure liquidity bubble, a temporary equilibrium that depends largely on the US and Chinese governments and – as do the IMF – that a sustained recovery requires a rebalancing of US and Chinese savings rates. Some other observations: the Chinese growth rate is slowing right now; liquidity is fueling a rising oil price trend. And forecasts: the US Fed will start raising interest rates within 6 months; asset prices will weaken next year.

There is a growing sense that the worst of the global recession is over. There is also further evidence that conditions are improving in New Zealand. Meanwhile there are not many events due in the next couple of weeks to rattle confidence in the recovery scenario. This is a backdrop that would normally favour a higher NZ dollar, just like the old days.

The problem is that a return to the old days seems inconceivable; surely people and policy-makers will change their ways? Well, that is yet to be determined. Currently we can point to high levels of global liquidity. We can point to speculative activity in global assets markets. And we can point to central banks reluctant to act, for fear of derailing the recovery (or our central bank threatening “the OCR could still move modestly lower“). All reminiscent of 2003.

Eventually, though, there will be fiscal and monetary tightening. It is unlikely that any exit strategy will occur smoothly. Thus there is plenty of volatility ahead. It is tempting to anticipate this policy response by selling NZ dollars now but the NZ dollar is likely to move higher in the near-term.

Background articles …

1) Growth rates have proven to be generally better than feared in the June quarter (NZ and Australia yet to be reported) with growth in Germany and France amongst Europe, and generally in Asia. But overall output did decline in the Eurozone, as was the case in the US. Both paled besides Russia. These data, plus more recent figures pointing to improvement, have prompted economists to increase growth predictions (WSJ) for second half 2009. It appears the worst is behind us.

2) There has been more confirmation of a local recovery also: confidence up in the general monthly BNZ survey; pockets of regional job recovery reported by Hays Specialist Recruitment; greater confidence about housing in the quarterly ASB survey; and, more forward-looking, Infometrics forecast the fast-population, slow-construction mismatch to show as 11% higher house prices over 12 months.

3) In the US corporate world, 91% of US S&P 500 companies have reported June quarter results and the pattern is clear: US profits are still rising faster than expected for most but sales are still falling – down 5% in the quarter – and meanwhile corporates are sitting on near-record levels of cash; the market has re-rated share prices but not near-term earnings, thus pushing the P/E on prospective 12-months operating earnings higher but at 14.4 it remains below the 18-year average of 18.4. The implication: there is potential for further sharp share price rises IF sales growth were to emerge.

4) Here is where policy becomes relevant. At present the central banks are adopting a stimulative stance, such as the Fed maintaining “exceptionally low levels of the federal funds rate for an extended period“. But eventually they will have to unwind the huge monetary stimulus in place. When? Some point to 1937 and suggest the central bank response will be slow and gradual. But there is also the lesson of the too-slow US tightening of 2003-2004 to keep in mind.

5) Meanwhile signs of the old excesses are already emerging; on Wall Street; and in the local housing market with banks again offering high LVR loans and real estate agents talking of missing out.