Opinion: Capital outflows and weak AUD to pressure NZD below 70c

By Roger J Kerr The NZD/USD exchange rate has returned to the brink of depreciating below the 0.7000 level that it briefly touched in mid-December. The rebound upwards in the Kiwi dollar that took it back to 0.7400 over the Christmas/New Year period appears to be well and truly over. The forces that drive the Kiwi dollar value have certainly turned more negative over recent weeks. The dominant influence over the NZD/USD rate is the AUD/USD exchange rate. The Aussie dollar has been falling out of favour with international investors and currency traders as base and precious metal commodity prices pull back down. The Australian sharemarket has been hit hard over the last week, falling to three-month lows, as equity investors lose confidence that commodity prices can keep going higher. What has changed in the global commodity markets is that the Chinese tightening of monetary policy has raised serious questions as to continued strong Chinese demand for commodities that Australia produces. As activity levels in China's property construction sector adjust downwards even slightly, it has a major ripple affect on the delicate balance of demand and supply that determine commodity prices such as coal, iron ore, copper, nickel etc. The international CRB Commodities Index that measures 25 major commodity prices has recoiled sharply from 280 to 265 over the last week. The Australian dollar has been rapidly sold below 0.9000 to 0.8840 against the USD, although as I write this piece the AUD has recovered back to 0.8900. The Reserve Bank of Australia will still be increasing their interest rate again by 0.25% today as they remove the monetary stimulus put in place with super low interest rates 12 months ago. Economic data in Australia supports the interest rate increases, however the FX markets have already some months ago fully priced-in Australian interest rate increases at this time, and therefore the actual increases have not propelled the AUD any higher. Likewise, when the inevitable increases in the New Zealand OCR interest rate start some time between June and September this year, the Kiwi dollar should not be affected as the change is already built-in to the current exchange rate well in advance. The latest movement back down in global commodity prices was also partially caused by President Obama's threat to US banks that the US Government would restrict and limit their proprietary trading activities in FX, commodity, interest rate and equity derivative markets. More regulation is an inevitable outcome from the global financial crisis in 2008/2009, however restricting the major banks' trading will reduce market liquidity and potentially cause more volatility in price movements. US banks such as Goldman Sachs and Morgan Stanley are major players in international commodity markets and provide most of the market liquidity through their own trading and client derivative products to the participants who are the underlying physical buyers and sellers of the particular commodity. The weaker commodity prices over recent weeks have helped the USD exchange rate make gains against the major currencies (except the Japanese Yen). The economic news coming out of Europe continues to deteriorate with Portugal's and Spain's government finances now under close scrutiny following the difficulties with Greece. The Euro has been sold as a result, falling to below $1.4000 against the USD as currency investors reduce exposures to Europe. Whilst some economic indicators are improving in Germany, the rest of Europe has real challenges to support the ailing economies in southern Europe. Greek Government bonds are now trading at 4.00% above German Bund interest rates and the Euro exchange rate is weakening along with this spread increase. A pre-condition for the NZD/USD exchange rate to reverse direction and weaken back to the mid-0.6000's was a strengthening USD on global FX markets. It appears that his is finally happening, despite many forecasts for the USD to weaken further in 2010. The reality is that the European economy is going to take a lot longer to recover from the GFC that the US economy. Closer to home, the re-investment rate form Japanese and European investors in NZD denominated Uridashi and Euro-Kiwi bonds has fallen away to below 30%. There is NZD3 billion of these bonds maturing this month, so a similar reinvestment level will result in major NZD selling and capital outflows. It will be a real positive fill-up for the New Zealand economy this year if the NZD/USD continues its down-path to the mid-0.6000's. Exporter returns/confidence will be lifted as our international agricultural commodity prices have increased near to their record highs. The economic recovery still needs to be export industry-led, and this does now look more likely with the NZD/USD reversing back downwards. * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com