Roger J Kerr wonders whether the 'phase 1' trade deal and swine flu factors are game-changers for the Kiwi dollar

The trade war cloud that has hung over the NZD and AUD currencies for the last 18 months may have only been partially lifted by the “phase one” trade agreement reached by the US and China last Friday. However, sufficient progress appears to have been made to have the pessimists in retreat in respect to the global economy and the optimists more on the front foot.

Whilst existing import tariffs have not been removed at this stage, there appears to be more cooperation and goodwill between the parties to move on to phase two of the negotiations and tackle the thornier issues of intellectual property rights, technology transfer and state subsidies to Chinese companies.

Progress also appears to have been made on a pact on the Yuan currency value.

The Chinese have purposely devalued the Yuan’s value since the trade talks blew up back in May to soften the border tax blow to their manufacturing exporters into the US.

The ability to manipulate the controlled currency lower also sent a message to the US that it was the US consumer who ended up paying for the import tariffs in increased prices, not necessarily damaging the Chinese economy (Chinese exporters being compensated for lower sales/lack of competitiveness through a lower Yuan value).

However, it has long been the view of this column that it has always been in the interests of China to reach a trade deal sooner rather than later, as their economic growth performance would suffer if the global economy went into recession as a result of a prolonged trade war.

The Chinese may have had the patience to “play the long game” and wait for Trump to be out of the White House, however they are also pragmatists and need to import US agricultural products to replace protein production shortfalls as a result of the African swine flu decimating their pig industry.

Yuan currency direction to reverse?

Given the positive outcome in Washington last week (even though it may not go far enough to completely satisfy the financial and investment markets) the Chinese will not be devaluing the Yuan any further.

The Yuan weakened to $7.1500 against the US dollar ahead of the trade talks last week, however, has since strengthened to $7.0900.

Further Yuan gains to below $7.0000 on a weaker USD generally seem likely and this has important implications for the Australian dollar value, which is highly correlated with the Yuan/USD rate.

A recovery in the AUD against the USD to back above 0.7000 has been justified on the back of high export mining commodity prices and an improving Aussie economy. However, over recent months the AUD/USD rate has bumped along the bottom in the 0.6700/0.6800 range due to RBA interest rate cuts and trade war/global economic risks holding it down. The AUD breaks out of a 20-month downtrend if it trades above 0.6900.

Two factors to change the Kiwi dollar outlook

The clear progress on reaching some resolutions on the China/US trade negotiations must be viewed as a positive for the Kiwi dollar value on two counts: -

• Over the last 12 to 18 months whilst the trade wars caused serious risks to the global economy, investment funds flowed into safe-haven currencies and assets such as the Japanese Yen, Swiss Franc, the US dollar and gold, and investment funds moved out of growth/commodity currencies like the AUD and NZD. It now should be expected that the investment managers will start to unwind their safe-haven currency strategies and return funds back to undervalued growth/commodity currencies. The time of year is also interesting in this respect with currency managers/traders more likely to square-up FX positions and take their profits ahead of Thanksgiving and 31 December year-end bonus periods. Speculative positions short-selling the NZD against the USD are at record high levels, as the Kiwi recovers towards 0.6400 the pressure will be on to buy-back the sold NZDs.
• Despite the trade wars and very weak business confidence/investment sentiment in New Zealand over the last 18 to 24 months, the NZ economy has been a top performer compared internationally with GDP growth rates above 2.00%. As global economic risks subside and given the lower currency value, lower interest rates, high export commodity prices and Government finances in a healthy position to provide fiscal stimulus, the NZ economy seems set kick on to a higher growth phase (the complete opposite outlook to the majority of bank and economic forecasting group’s predictions). The expected improved economic fortunes do not suggest a weaker currency value and point to the NZD being undervalued against the USD at the current rate of 0.6330.

Swine flu impact on our export prices being underestimated?

The consistent increases in NZ beef and lamb export prices over recent times to record high levels have largely occurred below the economic radar of the mainstream media.

However, coupled with dairy commodity prices, these prices are the arguably the most important determinant of the performance of the New Zealand economy.

It is very instructive that whole milk powder prices held above US$3,000/MT through the winter months and have climbed steadily to US$3,140/MT over recent weeks through the peak period of volumes being supplied on to the Global Dairy Trade auctions.

Whole milk powder futures prices point to further increases to US$3,200 over coming months.

The African swine flu has wiped out nearly 50% of China’s pig herd and they are by far the largest pork producers in the world.

The Chinese will need to import 10 million tons of protein to replace the domestic pork production shortfalls over the next 12 months.

It will take several years for the Chinese to rebuild their pig herds and production.

It seems that the massive Chinese demand will outstrip imported protein supplies and force our beef, lamb and dairy prices a lot higher yet.

The implication of this potential boom scenario for our primary produce exporters is that the NZ economy (and thus exchange rate) will benefit.

The downside is that our export prices set domestic prices for meat and dairy, and thus domestic food prices and inflation can only increase.

The RBNZ may finally get what they wish for, with higher inflation caused by swine flu in China, not by cutting interest rates in New Zealand.

Pound strength may be short-lived

Reports of progress towards a UK Brexit deal with Europe sent the Pound Sterling exchange rate soaring two cents against the USD on Friday 11 October (the largest daily move in 20 years) to US$1.2670.

As a result of the latest bout of Pound strength the NZD/GBP cross-rate has decreased to 0.5010, a level that local GBP exporters should be taking advantage of to hedge forward.

There is certainly no guarantee that the Pound will hold its gains if Brexit is extended past the 31 October deadline date and UK politics tumbles into further turmoil.

It has been the contention of this column for many months now that the USD would weaken against all currencies if and when progress was made on a China/US trade deal. The US dollar has lost ground against the Euro to $1.1040 following the “phase one” announcement last Friday, further US dollar losses are forecast.

New Zealand’s inflation date for the September quarter is due for release on Wednesday 16th October, a quarterly increase above 0.60% will be seen as positive for the Kiwi dollar.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.