fxmatters

The NZ dollar, and close allies AUD and EUR, appear stuck – stuck ahead of a sharp move. But in which direction? Falling share prices and imminent interest rate cuts suggest the break will be downwards. The JPY trend reversal and the possibility of post-easing rebounds suggest the break will be upwards.

I’m going with a break upwards, although the level of uncertainty is admittedly high. A number of factors point to this direction. First, it is worth noting that US bank shares did rebound from their low point during the week (and Australian share prices are actually rising), although this is a weak argument for any further share price strength. More significantly, the JPY has stopped rising, suggesting the carry-trade unwind may have come to an end, consistent with the renewed issuance of NZD Uridashi in recent days. Third, the RBA, ECB and RBNZ are likely to cut cash rates in the next two weeks (see local expectations). This would typically produce currency weakness going into the event but a sharp currency rebound afterwards would be in keeping with other currency responses in recent weeks.

Longer-term there are two further compelling factors: one is the current AUD weakness; the other the current USD strength. The JPY turnaround leaves the USD as the sole favoured reserve currency at present, especially with concerns lurking about the possibility – albeit slim – of a EUR breakup (see Economist article). This is surely the best of a bad bunch filtering to the top. Either it will reverse of its own right, weighed down by mounting US debt, or governments, with their renewed appetite for intervention, will sell USDs to stem volatility, maybe after the April G7 meeting.

Even more anomalous at present is the weak AUD. There are some very real fears about some eastern European economies such as Hungary. Meanwhile the Australian economy and banks are coping well with the global crisis (the Australian December quarter GDP growth to be released next week may even be positive). And yet the AUD/USD has fallen only slightly less since Jul-08 (-33%) than the HUF/USD (the forint, -38%). In other words, currency traders have not been too discerning in the rush to reduce risk in the last seven months. But Australia is far better placed than Hungary (and many other economies and financial systems). Exchange rates are likely to reflect this at some stage, probably as a generally higher AUD.

And where the AUD goes, the little NZD will follow.

The US share market rally of the previous week came to look like a dead cat bounce last week. The problem was although the US fiscal package was huge, as expected, there was vagueness about how the US financial system, and the economy as a whole, would be shielded from banks’ bad debts.

Problems didn’t end there, mind you. European discussion and statistics were negative. Japanese data have been likewise this week. The G7 called it a “severe global economic downturn“.

The end result for currencies is a firmer USD and JPY but, significantly, the movements were relatively small and recent highs have not been broached. Equally telling, the strongest currency last week was the Chilean peso, buying coming before and after the 2.5% Chilean lending rate cut. In other words, markets are responding to signs of aggressive policy initiatives.

Meanwhile the Australian economy is not faring too badly judging by the small rise in jobs during January. More figures like this and people will come to believe the RBA’s forecast of an Australian economic “pick up from late 2009″.

All in all, the broad flat-to-rising NZD scenario depicted last week still appears the most likely.

The scenario of sideways-trending major currencies appears to be playing out. In the last three weeks the JPY has brushed with its late-2008 highs against the USD and EUR but has failed to push higher; the EUR/USD has remained well above its Oct-08 low. Even the GBP has now stopped falling.

A lack of clear upward or downward trend amongst the major currencies tends to dampen the likely range for the NZD cross-rates. So even though the NZD hit new recent lows against the USD, EUR and JPY last week, it requires a lot of negative local (NZ and AUS) news to push the NZD significantly lower against these three currencies. No doubt the local news will be generally negative in the weeks ahead, but equally people are already anticipating plenty of tough times to come. In short, there is a good chance we too have reached a point of inflection i.e. the NZD stops falling. Whether this is the ultimate low or not will not be known for many months but, for now, current exchange rates offer good buying levels for the NZD.

Supporting the case for at least a near-term end to the NZD decline, the US share market rallied strongly last week. For all the negative US news, the S&P500 (chart) also remains above the low point of November. Any sustained pick up in global share prices is likely to be positive for the AUD and NZD. Of note, the Brazilian Bovespa share index has risen 12% in the last couple of weeks, one indicator that there is some appetite for risk internationally.

The connection between Brazil and the NZD comes through the AUD. The AUD often moves in accord with the Brazilian real (BRL) and Brazilian share index. Last week the AUD/USD posted a 5.9% gain, although local (i.e. AUS) factors are also coming into play. The RBA delivered a 1% rate cut but they also inferred that they are coming to the end of the easing phase. The futures market shows people sharply revised upward the anticipated low point in the Australian interest rate cycle (see Futures).

In sum, much bad news has been delivered. Much of the interest rate response has also been delivered by central banks. More will come but markets could well respond strongly to any news hinting of improvement. The AUD has avoided new lows at a time of sharp RBA easing and appears to at least be heading sideways, possibly about to appreciate. A stable-to-firmer AUD suggests likewise for the NZD (except against the AUD itself).