fxmatters

It is useful to think of NZD/USD exchange rates as the product of three rates: how many AUD per NZD, how many EUR per AUD and how many USD per EUR (i.e. NZD/USD= NZD/AUD x AUD/EUR x EUR/USD). This tends to isolate (although not completely) the USD effect in the EUR/USD exchange rate and the NZD effect in the NZD/AUD rate. For example, a weak US economy and low US interest rates will tend to show as a high EUR/USD, while a weak NZ economy and low NZ interest rates will tend to show as a low NZD/AUD; as at present.

The link in the middle is the AUD/EUR, in part a measure of the relative strength of the Australian economy. The Australian economy is growing relatively better than most at present and the RBA is again considering raising the Australian cash rate. Accordingly the AUD/EUR was recently at its highest level in over 20 years (peaking around 22% above its 20-year average). It was this pressure that was primarily behind the NZD/EUR rising above 57 euro-cents in September, a ‘mere’ 14% above average. Since mid September both euro cross-rates have declined but is this the end of the AUD rally?

The core driver of the AUD/EUR is relative interest rate differentials, as captured by the difference in 2-year swap rates, in turn heavily influenced by commodity prices. As always, it is more how the differential will change as opposed to its present level: should Australian 2-year swap rates (now 5.2%) rise by 1% relative to Euro swap rates (now 1.5%) in the next 3 months then the AUD/EUR is likely to be 10% higher. Conversely a narrowing by 1% will likely result in a 10% depreciation.

At the heart of this judgement is what policy stance will the RBA and ECB adopt? It is the risk of faster than anticipated RBA tightening that appears the major risk (cash rate currently priced +0.5% to 5.0% within 12 months). Around three-quarters of Australian exports are to Asia these days and Asia is growing rapidly, resulting in high Australian export prices and strong capital investment. Australian employment growth – to which the RBA are sensitive – appears to be accelerating. This momentum could force a faster tightening than currently expected, keeping the upward pressure on the AUD/EUR and, in turn, an upward bias to the NZD/EUR.

The end result: the NZ economy may be struggling but a strengthening Australian economy will likely filter through to a stronger NZ economy eventually, and meanwhile keep upward pressure on cross-rates such as the NZD/EUR.

For all the currency volatility of recent weeks, the NZD remains range-bound, pushing towards the 20-month band high against the USD and toward the low versus the AUD (and CHF). Seen from this perspective, the NZD is caught between a weakening USD and strengthening AUD. Step back even further and this dichotomous force exists while expectations of easy and/or easier global monetary policy prompts general buying of risky/growth assets such as shares, commodities and the AUD, only to be reversed when global growth prospects are threatened either by renewed anticipation of tighter global monetary policy and/or another negative shock. To determine the likely NZD trend requires determining which global force will dominate in the next few months (more so that what might happen locally).

The reality is that a shock could occur at any time, and that tighter global monetary policy is inevitable – eventually. Hence the chance of a sharp NZD fall remains a material risk at all times. Right now, though, the key driving force is the prospect of easier US monetary policy and hence the immediate risk is of a higher NZD/USD. Recall that the US Fed has the objective “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Last Friday we learnt that the US unemployment rate remains stubbornly above 9.5% (that’s over 14 million people looking for work). Last month the FOMC warned that it “is prepared to provide additional accommodation if needed to support the economic recovery” – that’s after easing monetary policy in August. This Friday, a speech by the Federal Reserve Chairman Ben Bernanke at a Boston conference (see Calendar) could heighten speculation of an FOMC easing at the 2-3 November meeting.

With or without a US monetary policy easing in November, the issue is not likely to go away quickly: the prospect of another US quantitative easing is likely to remain a key focus of markets for the next few months (see for example Rogoff’s Why America Isn’t Working for a discussion of the policy dilemma).

At the end of the day, a Fed easing is an easing and anticipation of such a policy change tends to prompt USD selling. That said, the nature of easier US monetary policy at present does raise longer-term concerns for the USD also. With the overnight interbank deposit rate – the Fed funds rate – already targeted between 0% to 0.25% p.a. there is little scope for the traditional lower-the-cash-rate approach to monetary easing. Today the Fed is resorting to “printing money”. This is now taking the form of buying US government debt off the public and paying for this debt with new deposits at Federal Reserve Banks i.e. new money that can now be used within the wider banking system. In August the policy change initiated by the FOMC will fund around $300 billion of the expected $1,200 billion annual US fiscal deficit. On the table at present is the prospect of the Fed providing the money for another similar, or even higher proportion, of the government revenue shortfall. Besides pressuring the USD, this easing tends to lower long-term US interest interest rates (the $1500 billion quantitative easing of earlier years is estimated to have lowered rates by 0.5% – refer Sack).

Anticipation of having to resort to further quantitative easing is likely to pressure the USD in the weeks ahead. Meanwhile the contrast between the US and Australia is evident with the RBA contemplating monetary tightening in November. The net effect could be the NZD/USD pushing towards 80c once again. Whether a high NZ dollar can be sustained, though, will probably depend on how long we have to wait for the next negative shock.

Background on the Fed (refer www.federalreserve.gov) …

• At the core of the Federal Reserve System is the US Federal Open Market Committee (FOMC), a committee consisting of the 7-person government-appointed Board of Governors of the Federal Reserve System plus 5 Presidents from the 12 regional Federal Reserve Banks (the 5 always including New York)
• The FOMC meets at least 8 times per year to decide on the appropriate monetary policy setting with any change the result of a majority decision
• The buying and selling of securities is executed by the Federal Reserve Bank of New York
• The 12 regional Federal Reserve Banks are ‘owned’ by banks based within each region but return on equity is limited to a 6% p.a. dividend (i.e. no special dividends, no capital gains), with any surplus profits distributed to Treasury (the combined Federal Reserve Banks 2009 net income of $53.4 billion was distributed as $1.4b dividend, a record $47.4b to Treasury and $4.5b retained as capital)