fxmatters

My warning last week of potential for weak share prices in July (and maybe through to October) and hence potential for a weaker NZD during this period is not universally shared, as to be expected.

There are two weak parts to the argument.

First share prices may not weaken. JPMorgan was one institution to come out with its view last week that we should expect positive earnings announcement surprises come late July, when the bulk of US non-financial quarterly results are released.

Second the currency-equity link has weakened in recent weeks, as evidenced by the NZD/USD rising 0.5% last week while the S&P500 dropped -0.3%. Meanwhile there are other conflicting forces acting on exchange rates such as commodity prices peaking (Tuatara) and China’s repeated calls for a lessor USD role as a reserve currency (Reuters). The NZD appears caught in the middle of these forces, wavering amidst these global forces rather than reacting to local news such as declining NZ GDP.

The bigger picture appears more one of wait-and-see. There was a burst of new confidence in markets from mid March through to early May that included the NZD/USD rallying from near 50c (but also the NZD/AUD moving broadly sideways). We are now seeing this confidence reflected in economists’ forecasts, including the OECD’s first global growth forecast upgrade last week in many months. That markets reacted first is quite normal. More recently market movements suggest some ambivalence about the next stage. While it is reasonable to expect better times ahead – and most do – the enormity of the current problems suggest ’shocks’ could just as easily be negative. The forecasting difficulty is whether the small increases in US jobless claims and bank credit default swap (CDS) indices in the last two weeks are just noise or whether they warn of a larger negative shock ahead.

While US ISM and jobs figures this week may help, it may be several weeks yet before the next major move becomes clear.

In the meantime there is no compelling evidence yet to suggest the equity-currency link has been entirely broken. The S&P 500 has fallen over 3% in 21 weeks during 2008 and 2009, and in 15 of those weeks the NZD/USD has fallen also (i.e. most but not all). History has shown the next few weeks to be a period when markets are prone to large equity sell-offs. Current circumstances appear ripe for such a negative shock again. There is no certainty of a share and NZD fall but it would be prudent to take advantage of any NZD rallies at present to hedge against a weaker NZD if that is where your major risk lies.

To me the fate of the NZD still rests with the US share market. If the S&P500 drops in the next few weeks, so too will the NZD. If the S&P500 rallies, here comes 70c.

The seasonal forces favour the downside. In the last 20 years the S&P500 has shown an upward bias: there was a 60% more chance that prices would rally in a month rather than fall. Not for July. The market has fallen 7 of the last 10 Julys. The 20-year average S&P500 return for the September quarter was -1.3%; the average for the other quarters were positive. We are entering a time that was always going to create anxiety, even before consideration is given to current economic conditions and financial market expectations.

Now, 7 out of 10 falls does not mean the 11th month will be negative also. But with the way expectations have become hyped and with the trouble the global economy is in, prudence would suggest having some cover against falling share prices in the next few weeks; likewise cover against a lower NZD.

The general unwind of anxiety continues with gains last week led by the GBP and NZD, and by oil. The RBNZ did little to break the NZD free of the global trend, and is unlikely to do so in the near-term. The G8 finance ministers talked of exit strategies over the weekend, and the BRIC leaders will probably mention the same today, but governments and central banks are largely in “wait-and-see” mode at present. With little news of note expected this week (the Bernanke speech Wednesday being the most sensitive moment), the general re-weighting of portfolios from bonds and cash to equities will probably be the dominate driving force. Markets now appear optimistic about the risks ahead but over-reacting is typical in financial markets. In this environment it would not be surprising to see the NZD/USD push above the 65.9c high of the previous week but there is also a strong chance that any rallies prove to be short-lived.

The RBA Governor summed up the underlying global economic situation in his speech Thursday: the initial demand-cum-inventory shock appears to be passing into a stage where production is realigning with demand; but, going forward, global demand growth is likely to be moderate, thus dampening global growth prospects.

The financial market equivalent is the US S&P500 rallying over 13 weeks from 57% below the Oct-07 peak to down a mere 40% now (graph including versus previous slumps), and the NZD/USD rallying from 19% below the 15-year average to now 4% above average (the NZ TWI is slightly below average). The financial market parallel going forward would be a flatter profile for share prices and the NZD, albeit ‘flat’ does not adequately describe the probable volatility within any trend.

Before then there still remains the issue of when will markets transition i.e. when will the global share market rally and the risky-currency appreciation stop?

There was a hint in currency and money that this point was reached last week. The reaction in the share market was more equivocal.

First, the money markets. With the worst of the global financial crisis behind, attention now turns to how to unwind the huge monetary and fiscal stimulus in place (the socalled exit strategy). Such talk last week resulted in higher anticipated interest rates in the US (graph). The prospect of tightening, even though months away, will likely be a key theme ahead of the 23/24 June FOMC meeting. And typically rising US interest rates are accompanied by a rising USD/JPY.

Second, the share markets. Share markets held up remarkably well last week in light of the higher market interest rates. Further rallies are still possible even if there is a general nervousness about the sudden turnaround, such is the massive liquidity boost in place at present.

The combination of forces – plus the relatively robust state of the Australian economy – suggests the NZD could still rally higher in the near-term (especially the NZD/EUR and NZD/JPY) but that a peak is near.

Judging by markets this week, all is rosy. Global share prices are rallying. Oil is again over US$60/barrel. High yielding currencies are appreciating. All of which was dwarfed by Fisher & Paykel up 66% in a week. The problem is, all is not rosy.

This is very likely to be a relief rally – relief that the financial meltdown was avoided earlier this year. It is difficult to perceive that shares, high-yielding currencies and commodities simply trend upward for months to come. At some stage there will be renewed attention to the problems in different parts of the world and a significant turnaround in prices and exchange rates (e.g. the recession in Europe, the tighter government spending in NZ, the huge debt that FPA has to repay within one year). A starting point to guessing this turnaround level would be the S&P500 rally reaching 1000 i.e. another 6% higher or a week or two at the pace of recent weekly surges. Such a rally would also put the EUR/USD near $1.5 and the NZD/USD near 70c. All these levels are likely to be very appealing to those waiting to sell. At the very least, there will be sell orders concentrated around such levels.

Will the NZD get that high? That’s unknown. The NZD/AUD above 80c is a warning that the NZD is again too high. The current risk-buying momentum suggests the NZD could go a little higher. In terms of timing, the two sensitive events this week are the ECB policy announcement Thursday night and the US monthly jobs figure Friday. It is time to start planning a strategy to sell NZDs.