Category — New Zealand Dollar

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.

Commodity currencies have been beating up on the US dollar and the Japanese yen recently and yesterday was no different.  The Canadian dollar, the New Zealand dollar and the Australian dollar all hit new highs, an occurrence so common in that last couple of weeks that’s most traders simply yawned.  Some of the underlying support for these currencies comes from high commodity prices, especially oil and gold, of course.  But much of the gains should also be attributed to weakness in the US dollar and the yen carry trade.

It is pretty easy to spot the strength the commodity currencies have derived from greenback bears.  The data released in the respective countries has not been really great.  Canada’s inflation numbers yesterday printed lower than expected.  Australia and New Zealand have not released much data recently, and what has been released has been worse than expected.   But the rise of the Loonie, Aussie and Kiwi cannot be stopped.  And that can be traced back to the sluggishness of the US dollar.  And the market consensus after Fed Chairman Bernanke’s speech is that US interest rates are likely to stay the same for some time.  Bernanke also seemed more concerned about the slumping housing market than he has been in earlier speeches.  And so the commodity currencies should continue to benefit from the weak dollar.

The other factor fueling the fresh highs in this area of the forex market is the yen-based carry trade.  The interest rate advantage for Australia and New Zealand compared to Japan is enormous, and currency traders just cannot seem to get away from the high yields.  And that differential is likely to get higher as the futures market lists a 66% probability that the Reserve Bank of New Zealand will raise the country’s interest rates, already the highest in the industrialized world, at its next meeting.  Most currency analysts are pricing in another rate hike this year for the Royal Bank of Australia as well.

The appetite for risk (as well as the hunger for yield) in the market is tremendous, and the surging carry trade is reflective of that.  AUD/USD is at an 18-year high and NZD/USD is at its highest level since the currency was floated in 1985.  While the amazing rate of appreciation might be hurting the country’s exporters, the situation is only exacerbated by the weak greenback.  It is because of this phenomenon that the Canadian dollar is up 12% already this year, with the USD/CAD hitting 1.0416 this morning, its highest level since 1977.  But the latter pressure is not likely to go away anytime soon as many analysts are touting the weak US dollar as good for the American economy.

Two words have dominated the forex market recently: carry trades.  Much of the dynamic price action in foreign exchange has been influenced by the drive for yield best demonstrated by the carry trade.  Currency traders have made a killing borrowing Japanese yen and Swiss francs and using that money to fund high-yielding purchases in Australia and New Zealand.  But the story is about the changing nature of the international carry trade.

The big worry previously was that the problems with the US economy would spread internationally.  The slowdown in consumer spending and the subprime mortgage crisis would trigger a bout of risk aversion, spelling doom for the carry trade.  But the data released today shows those worries to be unfounded.  The US stock market has never been stronger, with the Dow hitting 14,000 this morning.  And foreign investment into US assets reached record highs, climbing $126.1 billion in May.  Japanese investors alone, already the largest foreign holders of US Treasuries, increased their holdings by $400 million, bringing their total to $615.2 billion.  The explosion in American investment certainly accounted for a lot of yesterday’s gains in USD/JPY, suggesting that the forex market’s appetite for risk is still alive and kicking.

The real danger to the carry trade lies elsewhere.  The Swiss franc has been the funding vehicle for those traders scared off by the relative instability of the Japanese economy.  This makes the franc’s recent rally disconcerting to those carry traders.  All elements are in place for a consistent appreciation: a strong economy, a consistent rise in prices and a near certainty of multiple interest rate increases by the central bank this year.  So it should be no surprise to those paying attention that the franc-based carry trade is beginning to unwind with USD/CHF hitting a seven month low.

There are also significant concerns regarding the yen-based carry trade.  A lot of the cheap yen has been used to buy New Zealand dollars, the latter being attractive by virtue of Zealand’s 8.00% interest rate.  This has fueled post-float highs in the New Zealand dollar with regard to both the yen and greenback.  But the New Zealand finance minister came out last night and said that the high domestic currency was causing undue pain for the country’s exporters.  Lacking significant foreign exchange resources, there is really not much the country can do, but the comments should still place a brake on some carry trading.

Japan might also prove discouraging to carry traders.  The odds are relatively high that the Bank of Japan will raise rates at its next meeting in August.  There is also an incredible amount of pressure from the United States and Europe about the unfair advantage that the undervalued yen gives to Japanese exporters.  And Japan actually has the resources to intervene in the forex markets and make it stick.  It is for that reason that some Asian traders, fond of the carry trade, are now using the Singapore dollar and the Chinese yuan as their funding currency.  I would not recommend this course of action, however, as the market for the latter two currencies is too illiquid.

So what should the average currency investor do about this situation?  You are probably okay sticking with the Japanese yen for right now.  The major yen crosses, especially the pound and the dollar should continue to gain.  It is true that the yen losses are overextended; the depreciation is not entirely supported by fundamentals.  But the market’s appetite for risk and hunger for yield should trump all other concerns for right now.

The primary market mover on June 11 was RBNZ’s intervention in the currency market to drive the Kiwi lower.  The central bank’s decision to sell the currency did move the New Zealand dollar lower against most major currencies.  Following up on that story, the Kiwi has shown signs of a rebound from yesterday’s lows.  The country still boasts the highest interest rates among highly-traded currencies in the forex market.  As such, the Kiwi is attractive to institutional investors, including multinational banks and pensions funds.  But most currency market analysts believe that if the currency appreciates again, the RBNZ is likely to intervene in the foreign exchange market again.