fxmatters

The global financial markets continue to walk a tight rope. The momentum favours growth and rising share prices, and hence a higher NZ dollar. However there are serious questions over whether this growth momentum can be maintained next year, especially as fiscal and monetary policies are inevitably tightened. Central banks such as the RBNZ, BOE and ECB are downplaying any potential tightening and the US Fed will probably do likewise this week. Hence the NZD/JPY, NZD/EUR and maybe NZD/USD head higher for now, caught in the global risk-buying spree.

Key events shaping the future …

1) Leading indicators continue to point to higher near-term global production, consistent with output being raised to match demand that has now stabilised (but demand not necessarily increasing much). This output recovery theme does not appear to be finished yet (see Danske Bank for overview), and hence neither has the rising share market trend probably ended; in turn suggesting further upside for currencies like the AUD.

2) This global recovery is at last showing for NZ exporters, whole milk powder prices rising by 26% at the recent Fonterra auction. Meanwhile local retail spending edged higher in July (Paymark) and the continued housing recovery in July (Barfoot) suggests more spending growth to come. These news items should be sufficient to see the NZD stay with other rising currencies such as the AUD and BRL.

3) However the NZD is likely to lag, rather than lead, the AUD higher judging by the relative interest rate shift last week: interest rates are priced to increase in both countries next year (in spite of the RBNZ’s warning of possible further easing) but Australian 90-day bank bills rates are now expected to be 1.2% higher by March (up 0.4% last week) while the equivalent NZ rate is expected to be 0.5% higher (up 0.1%). This implied rising interest rate differential is likely to see the NZD/AUD remain low in the weeks ahead.

4) Interest rate differentials also look likely to play a greater role in the major exchange rates. Higher US yields last week saw the USD/JPY rise and EUR/USD fall. While this stalled the NZD/USD rally, it also accelerated the NZD/JPY rally and NZD/EUR rallies. Rising share prices will likely see these later two trends persist.

5) Just how much US interest rates are about to rise will become clearer this week following the FOMC meeting (see Calendar). The US Fed are expected (see Bloomberg) to allow their Treasury-buying programme to end (having bought around one-third of Treasury bonds issued since late March). But they will still buy large volumes of mortgage-backed-securities through to year-end and, using other central bank as a guide, will probably still be emphasising easy conditions rather than focusing on an exit strategy (just yet).

Earlier in the week it appeared the NZD might finally drop but it was not to be. It soon became clear that the global appetite for risk is the dominant force at present and it now looks like the NZD/USD will be dragged higher by global forces in the near-term, probably to 70c. However there remains the risk that any near-term rally proves short-lived.

Key events shaping the future …

1) The AUD/USD pushed through its early-June high. This is the key pressure on the NZD. Tellingly, the AUD/EUR continues it climb towards the trading range of the previous 5 years (centred on 60 euro). The RBA now appear to have removed an easing bias, the Governor referring to upside risks. Look for more on this view at the 7-Aug Statement of Monetary Policy but meanwhile any bullish Australian data release (see calendar) will push the AUD higher.

2) The backdrop to the AUD rally is another surge in global risk investment. Shares and commodities generally rallied last week. There was a taste of things to come when the Chinese Shanghai Composite Index of shares dropped 8% at one stage Wednesday following central bank tightening. However the lack of follow-through overnight in other markets and the quick return to rallying Chinese shares are signs of strong demand for risk at present.

3) Another bullish equity technical indicator was triggered. The Dow Jones crossed 10% above its 200-day moving average, a milestone that 18-out-of-21 times has been followed by 3-month gains. Behind the current rally is the higher-than-forecast earnings of about three-quarters of the 148 companies in the S&P 500 that released June quarter results last week.

4) Of course, there are other ways to read from the past. A US researcher lists 7 signs that would mark a secular bottom to US share prices and suggests the low point has not been reached yet – the current level of debt being a major constraining factor. (A technical parallel to this fundamental view is the Elliott Wave interpretation that the S&P 500 rallies another 5% before dropping sharply).

5) Also something to keep in mind further down the track, the US and Chinese authorities appear agreed that they would prefer a stable US dollar. Stability will not happen but these comments do hint at policies to support the US dollar to come eventually (or at least not to further weaken it).

6) Our own authorities are also unhappy about the NZ dollar, judging by the RBNZ warning of ‘further easing in financial conditions’. This is reason to believe the NZD/AUD stays low but, as the quick NZD/USD turnaround Friday showed, it is global forces that are more dominant on other NZD cross-rates.

The stand-off continues. Share prices pushed higher. Significantly for some traditional analysts, the Dow Jones Transportation Index surpassed recent highs. Commodity prices were up. The ‘risky’ currencies such as the NZD, AUD and HUF appreciated and the low-cost JPY depreciated. All signs of a greater appetite for risk. And yet the currency moves remain unconvincing (the NZD edged up to a new high at 66.28c but not so the AUD, CAD, EUR or GBP – likewise for a wider set of risky assets), while the general risks around economic growth and company profits remain high. I still believe these are good opportunities for people looking to sell but a very risky time to be buying.

This week sees the RBNZ once again decide on the Official Cash Rate. No change to the 2.5% current rate is expected. The RBNZ appear caught between a rock and a hard place (as usual): they will be concerned that a rising NZD will curtail any export pickup but they will not want to fuel any faster housing recovery by reducing the cash rate. The net effect may be to prompt the Governor to warn about the need for restraint with debt accumulation, and to state the RBNZ’s willingness to consider more direct means to slow credit growth in future.

So much for a weak US share market in July, or at least the 7% S&P500 surge last week did not indicate weakness. Unfortunately movements of this magnitude are more a sign of the volatility and uncertainty at present rather than a compelling signal of confidence (5 of the last 7 weeks with 5%-plus surges have been followed by a weekly decline!). Importantly the earnings season is only just starting, with only 38 of the 500 S&P500 companies having reported so far.

The most likely scenario remains a broad sideways pattern for global financial markets, including the NZD, while the risk of a sell-off of risky assets cannot yet be dismissed. Tellingly, the S&P500 remains below its June high; likewise the major currencies, including the NZD, against the USD. Very little is ever certain about the future but current trading still looks more like noise.

Support for a scenario of general financial market sideways movement came from two quarters last week: Morgan Stanley forecast the US government 10-year bond yield to range trade between 3-3.75% over most of second half 2009 (any growth surge being tempered by underlying subdued US consumption growth – sound familiar?); and CBA predict the oil price to broadly centre on US$60/barrel for the rest of the year (there being excess supply available to meet any demand increase).

The NZD/USD slipped further last week, mainly on the back of global risk aversion (the JPY was strong and share prices dropped) and other negative influences on the AUD (RBA say there is scope for further easing of monetary policy, commodity prices declined and there was the unusual cancellation of a Chinese coal shipment).

At 62.8c (Saturday morning), the NZD/USD is still within 1% of its average rate since entering the current trading range during the week ending 22 May. In other words, the NZD/USD is down but there is little evidence at present to suggest it is doing little more than trading in a broad sideways pattern.

That would not be unusual. In the last four years the NZD/USD market has existed in such states approximately half the time e.g. the NZD/USD ranged about 2-3c either side of a 62.4c average for 23 weeks between Mar-06 and Aug-06. At other times the period of range trading was longer. Seen from this perspective, the current ranging period of 7 weeks so far is brief.

Eventually, though, the NZD/USD (and other NZD rates) will trend again. As mentioned in previous weeks, there is a strong chance in the near-term that any break would be downwards. As time goes on, the risks for the NZD/USD swing more to the upside as the sheer volume of offshore-owned debt in the US weighs on the US dollar itself.

The NZD showed outright weakness last week, falling against the other 37 currencies monitored here. Several factors have been blamed including lower global share prices and lower dairy prices (although not for 2010 deliveries). While tempting to extrapolate the NZD weakness forward, it should be recalled that the NZD has been the weakest of the 38 currencies in 8 weeks from the last three years but was lower one month later only three times. As always, recent changes are not necessarily good predictors of future exchange rate movements.

Local news this week are likely to be more upbeat, including improving business confidence and more house sales (but a still flat retail sector). Globally it will probably be the G8 meeting July 8-10th that commands attention, particularly the issue of a replacement reserve currency for the USD. Any radical change seems unlikely in the current environment, and more likely soothing words will be expressed when Presidents Obama and Hu have a sideline meeting.

In other words, markets remain at a crossroads. The biggest near-term risk appears to be of further share market weakness, and hence a lower NZD, especially with the backdrop of a weak NZ economy and maturing Uridashis.

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.