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)

The deadlock is still not broken. The NZD/AUD at 79.8c is near midway of the 75.5 – 83.7 range of the last 18 months. The NZD/USD at 73.3c is above the midpoint of the last 12 months but remains within the 65.5 – 76.3 12-month range. Providing some upward pressure on the NZD/USD is the gradual recovery of the EUR/USD, and the coincident recovery of the US share market, more so due to the likelihood of prolonged low US interest rates rather than any harbingers of global growth. Therein lies the problem: the global outlook remains fragile; or, as the Bank of Canada put it, “the global economic recovery is proceeding but is not yet self-sustaining”. This is probably not enough to force another US easing this week but that is the direction of risk. Meanwhile the RBA is very much on hold, having attained average interest rates to borrowers, while the RBNZ appear reluctant to return NZ borrowing rates to average too rapidly due to weak local spending. There appears little ahead to break the deadlock while the risk of a sharp US share price fall – and hence NZD fall – remains high.

The stalemate continues. The general expectation is for global and local growth ahead but there is also awareness of the risks that abound. Some of these risks come into focus this week: US corporate earnings stream through from now for the June quarter; and June quarter Chinese GDP will also be reported. Growth in both areas has slowed, but by how much is yet to be revealed. Markets appear to be anticipating the worst at present. This sentiment – and the risk of confirmation – signals that a sharp NZD fall could occur at any stage. However the more likely scenario is that range trading persists. Picking the shifts within the range is a guessing game but with local spending constrained, with the RBA now on hold and with the European banks about to reveal their balance sheet strength – or lack of – next week the short-term risks appear biased towards a lower NZD/USD as well.

We come around once more to the monthly US jobs data. In fact we are moving into a period where news in several places have the potential to surprise (e.g. US data, RBA meeting and data, G20 finance ministers meeting next weekend, RBNZ meeting next week) – see calendar). But first the US labour market: the jobs growth in April was the largest since March 2006. The May growth will be a lot more, partly the result of temporary employment on the US Census, but maybe also enough to nudge the US unemployment rate a little further below 10%. Significantly, further evidence of a turnaround in the US jobs market will be the trigger for the US Fed to step up the tightening process and herald a period of US strength. The euro is already coming under pressure and strong US data would likely tip the balance further. Meanwhile in Australia the RBA are likely to refrain from another rate hike Tuesday, taking some of the sting out of the AUD as well. This mix of forces increases the odds that the NZD/USD stays around the mid 60s – or lower – having recently broken below the range of the previous six months.

The Goldilocks period continues. News of improving economies continues but it is not coming quick enough to force higher interest rates in the major economies. The result is share prices and other risky assets show a slight upward bias. And the NZD/USD does not fall.

There is some monetary tightening occurring. Singapore this week revalued the Singapore dollar after news of strong March quarter growth. And the RBA raised their cash rate again last week. Both factors are providing upward pressure on the NZD/USD.

These forces could see the NZD/USD run up towards the 2010 peak of 74.4c but they do not appear sufficient to drive the NZD out of the recent trading range. The most likely circuit-breaker still appears the prospect of higher US interest rates, and hence a higher USD (and lower NZD/USD). In the meantime, range trading persists.

Every now and then events come along that can significantly change markets. The US jobs report this Friday is such an event. A pivotal moment in the recovery will be when US employment increases and unemployment decreases. The US March job growth to be released Saturday morning (NZ time) – during a holiday in many parts of the world – could be strong coming after blizzards and recession and during a temporary Census employment boost. A big number (e.g. 400,000 or more new jobs) is likely to push the USD upward, and hence the NZD/USD downward, possibly sharply on the night. Nothing is certain with the future but this is one event where importers should seek cover and exporters sit back.

At the margin, the economic data of late are on balance positive, indicating growth here and generally abroad. This is promising. The NZ GDP release Thursday is expected to fit into this category. But the risks remain unusually high. There are numerous global examples of business failures, job losses and debt refinancing problems. There are mounting tensions e.g. within the Eurozone and between China and the US. All set against a backdrop where expectations in equity and commodity markets are relatively high, and where monetary and fiscal tightening is yet to occur.

The challenge for traders and investors is whether to focus on the gradual improvements or on the risks that still lie ahead? The answer will vary by each individual’s situation.

For me, the number of things that could derail the equity market rally appear too many. And if the equity market falters, so too will the NZ dollar.

A noteworthy risk was highlighted Friday, namely monetary tightening in Asia. There is more to come. A surprise monetary tightening by the Bank of India is of little global importance. Further tightening by China, including (gradual) CNY appreciation again, is another matter. Such an initiative is becoming more probable during April/May. And a Chinese tightening does hold the potential to shake confidence in the equity markets and drive the NZD/USD below its recent 68c floor.

The RBNZ have confirmed their expectation of a mid-2010 rate hike. However it is the US Fed’s initial tightening that will probably determine currency trends. The Federal Open Market Committee meet this week (result Wednesday morning NZ time). It is too soon to tighten yet but that could change quickly. At the start of the previous cycle in 2004 the Fed went from “accommodation can be maintained for a considerable period” to a rate hike within 6 months. A key trigger in the process was US employment growth over March-May. During this spell the USD rallied around 10% and the NZD/USD experienced a drop from around 70c to 60c.

At present, leading indicators suggest US job growth is imminent. If jobs do emerge, the Fed will quickly drop the current “warrant exceptionally low levels of the federal funds rate for an extended period” and soon after raise the overnight rate from its near-zero level. A USD rally (and share market fall) will occur and the NZD/USD would depreciate.

But recall, the USD was falling and US share prices were rising before 2004 was out. It was in the lead-up to the Jun-04 Fed tightening and during the early stages that the USD was favoured and the NZD was under pressure.

It may be too early for the Fed to signal a change this week but a re-run of 2004 is likely at some stage soon.

This week the focus shifts to the RBNZ. Add the likelihood that the RBNZ will repeat its call for a mid 2010 tightening to the global share market rally and the RBA rate hike of last week and the scene is set for the NZD/USD to rally this week.

In broad terms the economy is evolving as the RBNZ outlined in the December Monetary Policy Statement, albeit with the upside growth risks now less. There is much to be uncertain about at present including near-term global growth prospects, the impact of local liquidity requirements for banks that come into force 1 April and the policy measures to be unveiled in the 20-May Budget. Nonetheless the local growth rate is now higher and, significantly, the Australian economy is strengthening.

Meanwhile the cash rate is at unsustainably low levels. The appropriate policy path is to continue warning of imminent cash rate hikes but allow scope for reaction to the April/May policy intitaives; hence the likelihood that the RBNZ repeats the vague “begin removing policy stimulus around the middle of 2010″ line on Thursday.

Any NZ dollar reaction this week is unlikely to change the broader picture of a sideways trading NZD/USD with the probability of a revisit to 65c still high.