Sunday, July 5, 2015

What Drives NZD/USD

In my last post I mentioned shorting the NZD/USD. At the time of that trade, I only had a rough sketch of the thesis: 1) the chart already showed a breakout to the downside, and I was waiting for a retouch to confirm the resistance level around 0.71, 2) I happened to be looking into Fonterra and had developed a negative view, but I thought NZD/USD might be a better way to implement that short. 3) a quick calculation of fair value based on BIS Narrow REER showed me that NZD could go as low as 0.60, thus a highly favorable risk and reward.

Then Reserve Bank of New Zealand announced a (surprise) rate cut on 6/11/2015 and NZD collapsed below 0.71. New Zealand is now lowering rates while US is raising rates. I also got my technical confirms and went ahead with the short. During the past 2 weeks that trade works really well - the NZD has went down so fast that I’m now reassessing the situation and bracing for a pullback (but staying short).

It was a bit of an “invest first, investigate later” type of situation, and I wanted to catchup in terms of understanding what drives NZD/USD over the long run. So I plotted the chart below with 1) NZD/USD, 2) the Dollar Index (DXY), and 3) NZD real effective exchange rate.

The cool thing about currencies is that they do move in long, multi-year trends. In the next section, I listed out the major up and downs over the past 2 decades and did some research to explain the drivers. The short-one sentence summary would be this: the drivers of NZD/USD are USD strength, NZ’s growth differential vs rest of the world, interest rate differentials, and commodity prices/terms of trade. I'd put inflation differentials up there too but that has a more indirect effect as it really drives the market through interest rate policies.

What Drives NZD/USD through the decades

Summary of various NZD/USD trends

  • 1988 (not shown on chart) 
    • NZD collapsed from ~0.7 to ~0.55. NZ had stagnant growth and bursting of a commercial property bubble.
  • Late 1996 – late 2000 – Big downtrend from 0.7 to 0.4
    • USD was on a strong uptrend. US went through an investment boom and productivity spike which drove up USD’s real equilibrium exchange rate (think of a 2 dimensional plane with a) upward sloping savings – investment and  b) a downward sloping current account balance on the X-axis and real exchange rate on the Y-axis. The S-I curve is upward sloping while the current account balance curve is downward sloping. Here the USA have more investment, so the Savings - Investment curve would shift to the left, leading to higher real exchange rate)
    • On the NZ side, in 1997 the economy fell into recession with after 2 summers of drought. NZ was also hit by the Asian financial Crisis.
  •  2002-2005 – big uptrend. From ~.40 to .~74
    • General weakness in USD. USD was overvalued at its previous peak, but the structural factors that boosted USD were now reversing. The downward move coincided with bursting of the dot com bubble, and the subsequent low US interest rates. 
    • NZ has positive growth differential versus rest of world. NZ had a positive output gap and positive short term interest rate differential. Commodity prices were strong.
  • 2005-2006- dip from ~.74 to ~.60 then a rebound
    • The market believed that New Zealand was falling into recession, and GDP contracted slightly in December 2015. But this turns out to be a false alarm and GDP reaccelerated in 2006, and NZD/USD went on a strong rebound from 2006 to mid-2008 (~0.6 to >0.8)
  • 2008/2009 - a massive dip during the Great Financial Crisis. There was another dip in 2011 when NZD fell from 0.88 to 0.74 due to prospect of Eurozone breakup.
  • June 2011 – 1H2014: NZD/USD traded with general uptrend rising toward 0.89 
    • Context for 1H14. NZD benefited from diverging monetary policy versus the rest of the world. The market had gotten used to QE with US, Eurozone, Japan all in monetary easing mode. But in 1H14 the RBNZ actually hiked rates. NZD benefited from strong interest rate differentials (both spot and expectations). Meanwhile Fonterra and the dairy sector enjoyed historically high prices, so the country enjoyed strong terms of trade which propped up the NZD.
  • 2H14 to current.. big downtrend from 0.89 to 0.67
    • US Dollar Index went on a big spike. 
    • On NZ side, growth slowed and market had developed expectation of continued rate hikes which was not met. Dairy prices and commodity prices have collapsed. RBNZ came out with aggressive stance saying NZD is over-valued and actually intervenes to depreciate NZD. 
    • By June 2015 RBNZ cut the Official Cash Rate and set expectations for further rate cuts. NZD/USD dropped below a critical support level. 

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