fxmatters

One of the largest risks this year is of further credit-related issues. It is this factor that will likely see the NZD/USD revisit 65c in the next few months.

However we are also amidst a large mining boom in Australia, in turn the result of strong emerging economy growth – as discussed by the RBA last week [speech]. Of particular interest is the RBA’s expectation of higher terms of trade to come for Australia [given earlier in the month]. This would normally mean an upward bias to the Australian dollar.

History suggests that the risk cycle will win out in the short-term (i.e. over days/weeks) but, short of the major reversal in China, that the mining boom will probably dictate the AUD trend over the next 2-3 years.

One of the ways that these mixed influences have manifested recently is to push the AUD/EUR towards highs even while the AUD/USD has been slipping lower.

A similar pattern is noticeable with the NZD. The NZD/EUR does swing with shifts in the USD but the medium-term drift is upward (due largely to the AUD influence). Looking forward, the expected USD rally will likely see the NZD/EUR lower in the next few months but new highs for this cross-rate are still probable later this year.

After dealing to a heavy workload and a hacker, the regular fxmatters blog is back. Besides issues to do with time management and website security, the other lessons I take from recent months/weeks are twofold.

Lesson 1. The US dollar is not on a one-way downward path (and hence the NZD/USD is not on a one-way upward path). The last few months have proven that exchange rates are in a broad sideways trading pattern. There are many problems in the US but there are many financial problems elsewhere as well.

Lesson 2. The US is likely to exit their (huge) monetary rescue package sooner than Europe. The Fed comments imply this (including Bernanke speech). The data being released imply this. It is this fundamental monetary policy pressure, as much as concerns about Greek debt, that appears behind the current USD rally.

There is no sure thing when it comes to the future but one strong starting point is the likelihood of higher long-term interest rates in the US, a combination of high debt issuance and the removal of the US Fed as a buyer (and possibly changing to a seller).

The other high-probability event is that there will be further debt problems, again a risk heightened by the private sector being left more to its own means this year.

Higher US long-term interest rates and the odd debt problem suggest a few rough spells for the US share market, and hence share markets in general, further adding to USD appeal (as a flight-to-safety).

All in all, a run down to around 65c is to be expected for the NZD/USD over the next few weeks within a broad sideways trend.

The danger is we see what we want to see. That particularly appears to be the case at present. The NZD/USD remains entwined with global share markets and global risk trades in general. To unravel the mystery of where the NZD/USD goes next thus requires trawling through global forces. What you find amongst the various commentators are strong reasons why, say, the US share market will continue higher and others with strong reasons why it will fall. Unfortunately the evidence in support of each case is selective, typical of the confirmation bias we often display; we tend to notice information in support of our view and ignore the opposite.

The reality is the share market and the NZD/USD could go either way near-term. The rush into high-beta US stocks appears to be over but that still leaves the global output and earnings momentum to push share prices higher. Likewise the slow US commitment to exit strategies favours more upside. Then there is the bias towards higher share prices in December to take into account (S&P500 up 16 of 20 years).

But exit strategies will become more prominent. The global fiscal and monetary tightening will temper enthusiasm for risk – and hence the NZ dollar. Exchange rate choppiness is likely to result.

For now, hedging against a higher NZD/USD remains prudent. But also factor into any strategy the strong likelihood of a lower NZD/USD within the next six months.

The mixed nature of forces will probably also show in different directions for cross-rates. It is time to start thinking about the possibility of a weaker NZD/GBP but a stronger NZD/AUD.

The global unwind of the policy stimulus is underway. Japan signaled an end to their (modest) quantitative easing last week and Norway raised their interest rates. We get to learn where US, Eurozone and UK central banks are at this week, and just how aggressive the RBA intends to be. A 0.25% rate hike by the RBA is likely but the others are more likely to forewarn of tightening rather than act now.

Markets have already signaled their unease with the stimulus unwind, the S&P500 down 4% last week being noteworthy. No doubt there will remain some too-ing and fro-ing as people balance the conflicting forces of economic recovery and stimulus removal but it does appear we have moved beyond the goldilocks period. The new stage need not necessarily bring a downward bias to share prices and the NZD but it is likely to involve more downward moves than has been apparent for several months.

The traditional carry trade – the NZD/JPY and AUD/JPY – has kicked in again in the last couple of weeks, in line with another surge in global share prices and the recent RBA tightening. Even NZ news added to the pressure with inflation running faster than expected (but not high enough to concern the RBNZ).

In simple terms the driving force appears to be the huge US stimulus. Historically money creation on this scale has created inflation. In recent decades the inflation pressure has tended to come through in asset prices. There in lies the quandary. The global authorities know that facilitating the asset bubbles of earlier years was a mistake, so surely they will respond this time sooner i.e. tighten monetary policy.

Some are doing this already e.g. the RBA. Others such as the BOE are hinting that they are coming round to this thinking. Comments from US Fed Chairman Bernanke will be listened to closely this week.

In the meantime the global good-news story will continue, strong Chinese growth likely to be reported this week and probably higher than expected Australian inflation next week judging by the NZ out-turn.

This all adds to short-term upward pressure on the NZD (except against the AUD and CAD, and maybe excepting the GBP now) but the risk of a sharp turnaround remains.

There have been some atypical movements in currency markets in the last week or so but at the end of the day the global recovery story continues, share prices are still pushing higher and the central banks around the world are loathe to act, suggesting the current upward NZD/USD momentum is not over yet.

There have been murmurs of disquiet with a low USD, and hence high EUR and JPY as well as high NZD, but there appears no concrete action imminent.

Meanwhile stronger NZ economic statistics – including probably business confidence released Wednesday – and talk of a near-term RBA tightening suggest the local currencies remain to the fore of any rally against a weak USD.

The NZD remains caught up in global forces. Last week the NZD generally weakened, falling against 30 of 38 monitored currencies but it was the gain against the weakening USD (and GBP) that received most attention. Over 4 weeks the NZD has appreciated against 34 of these currencies with one of the exceptions being the AUD. In other words, the RBNZ has not managed to disentangle the NZD from the weak USD on the one hand and the strong AUD on the other. There is the possibility that the release of NZ June quarter GDP Thursday (see Calendar) may shake the NZD free a little but more likely the fate of the NZD will rest with the major global trends.

Here the key tension is mounting evidence of global improvement and a reticence by central banks to respond for fear of derailing the nascent recovery. This is creating an abundance of US dollars and a goldilocks period for risky assets, especially when priced in USD. This period cannot last and the question is when the (relatively) little bubble is pricked. Ten years ago the answer was more likely later rather than sooner, the attitude being any remaining problems can be patched up afterwards. The recent experience of the financial crisis suggests central bankers should not allow bubble-like conditions to persist. Already there is tightening occurring outside the largest economies Bloomberg.

One example of the imbalances that the current policy settings cause is the Chinese yuan. It could be argued that a weaker USD is appropriate given global conditions but the USD is not just the USD – it is also the Chinese yuan (and the Hong Kong dollar) as the yuan is very closely linked to the USD at present. The end result is the EUR/CNY has now moved above the long-run average and there will be increasing calls within Europe for either a lower EUR or a higher CNY.

It is unlikely that the meeting of G20 leaders Thursday/Friday will provide a reaction plan, nor the US Fed meeting Wednesday (Thur 6:15am NZ time). But market players will increasingly focus on exit strategies (i.e. tighter monetary policy) in the next few weeks.

In terms of the NZD/USD, the momentum remains upward but the risk of a sharp turnaround is high.

Any post-MPS NZD selling was brief and more than offset by subsequent buying. In fact the NZD was one of the strongest currencies in the world last week (slightly behind the Russian ruble), posting the ninth consecutive weekly NZD/USD gain. It is apparent that the RBNZ are reluctant to respond to the stronger NZD, conceding they believe there is little they can do to influence the NZD – the result was the NZD/AUD rising 1.5% over the rest of the week.

However, the NZD/AUD remains within the upper half of an approximate 77-83c range. It is likely to remain within this range, including moving below 80c once market participants return to focusing on the probable gap between any RBA and RBNZ tightening (i.e. the RBA moving much sooner than the RBNZ).

Meanwhile the NZD/USD strength rests on a weak USD and strong share markets. There are global forces that could reverse both or each of these trends quickly. A bias towards selling the NZD at these levels appears appropriate but that is not to say the NZD/USD could not rise further in the short-term.

Movements in financial markets went against the usual patterns last week – AUD, GBP, NZD up but so too the JPY, all happening while share and oil prices declined. Significantly another wave of Chinese share market weakness failed to spark wider large-scale selling.

There are many questions about sustainability of current share prices (and an upward trend) but global economic news keeps showing up evidence of improvement. Locally the signs of improvement for August include NZ housing activity again up judging by Barfoot’s Auckland sales, likewise dairy prices, while retail sales failed to kick ahead but are improved on first half 2009 judging by Paymark electronic transactions.

Policy makers are taking a cautious approach to the global green shoots, generally adopting a no-tightening-soon approach. Significantly the RBA passed up the opportunity last week to warn of tightening ahead, although their comments were non-committal. Over the weekend, the G20 said “fiscal and monetary policy would stay expansionary as long as needed to ensure recovery”. The danger with this approach is that it sets up a greater knee-jerk reaction some months ahead – the eventual tightening will remain a market focus.

In the meantime, the Reserve Bank of New Zealand are likely to take this offshore lead by central banks and, consistent with their own earlier comments, play down the likelihood of near-term interest rate hikes when presenting the Monetary Policy Statement Thursday 9am. They may even go so far as to drop the cash rate by 0.25% to 2.25% p.a.

These present mixed forces for currency markets: the delay to the inevitable global tightening and the current growth momentum imply a rising NZD; the prospect of a dovish RBNZ and current nervousness about global share prices imply ample downside risks as well. A prudent approach would be to put more weight on the RBNZ this week and sell NZD ahead of Thursday.

The currency, and financial markets generally, are largely in a holding pattern at present – the weakening GBP an exception – in part due to a lull in information releases, in part due to Northern hemisphere holidays and in part due to markets having reached a natural point of inflection. New information is probably required to shift sentiment strongly, one way or other. The US S&P 500 share price index is now 54% above its 6-Mar low. This is about where the rebound rallies ended for Italy and France in the 1960s, the US, Switzerland and Europe in the 1970s and Japan in the 1990s. There were post-crash rebounds at other times that have gone further but we are in the zone where the recovery glow has tended to wane (see Morgan Stanley on the history of bear markets). Meanwhile we also remain within the time of year most prone to share market falls and we have insiders selling while the general public are buying. And to cap it off, we know that governments will have to tighten monetary and fiscal policy at some stage over the next couple of years (the Chinese have started already, contributing to a 3.4% share market decline last week). This makes for nervous markets, and most likely volatility.

From a momentum perspective, the near-term bias is likely to be upwards, there being little to indicate that the ‘good news’ is about to stop. For the NZD, upward pressure is also likely to come from an RBA approaching the time of its first tightening (don’t discount the possibility of a surprise rate hike Tuesday – the Australian cash rate is at emergency levels no longer required and it is now 5 months since their last easing, the same gap waited back in 2002 before the first-in-the-cycle rate hike).

From a value perspective, current levels in the share markets and NZD appear over-priced relative to the risks ahead.

In sum, the NZD/USD at 70c remains a strong possibility. But that need not prevent the NZD/USD again reaching 60c before Xmas as well.