Deutsche Bank Markets Research

Global Foreign Exchange FX Spot Date 11 March 2014

FX Daily
Wheeler's got bottle, kiwi can't milk it
Graeme Wheeler will be the first G10 central banker to hike rates on Wednesday, lifting New Zealands OCR 25bps to 2.75%. Domestic indicators show a gradually strengthening economy and inflation starting to lift from a low level, paving the way for policy normalization. A relatively aggressive hiking cycle is already priced (25bps in pretty much each of the next four meetings through July and 150bps by the end of next April), external risks remain to the downside, and a general election now is looming (Sep 20). So the governor should be leery of stoking expectations, particularly with the trade-weighted exchange rate 50% above its long-term average and three standard deviations from its upward trend midpoint (chart 1). Its debatable whether the RBNZ even matters for NZD/USD. Post-2008, frontend US swap rates alone do a much better job of explaining how the kiwi has traded (charts 2 & 3). Whereas rate spreads only matter clearly when it comes to AUD/NZD, but this is if anything 5 percent too low; most models would peg fair value around 1.12-1.14. So perhaps its not too surprising that commentators have cast around for alternative explanations. And settled upon milk: The dairy price ran up 50% last year, gifting local producers a windfall. Supposedly, this relates to a structural ramp in Chinese demand as incomes rise and diets turn Western. Yet the IFCNs December 2013 Overview on Milk Prices and Production Costs Worldwide points instead to temporary factors -- disrupted production (foot and mouth disease in China) and crimped dairy economics for farmers in the US and Europe, who feed their herds grain.1 Either way, a strong supply-side response is ensuing, and parallels with iron ore should not be forgotten. Forecasts for milk prices have just started to move lower, underscored by last weeks 4% Global Dairy Trade auction drop.2 Its a space to watch even though the empirical link to FX is quite tenuous. EUR/USD has almost as high a correlation to dairy prices -- 75% versus 82% for NZD, measured on weekly levels since 2001 -- which should not surprise as the broad USD component in global commodity prices tends to be high. But translate this into the countrys terms of trade and the sensitivity of NZD/USD falls to a mere 11% (chart 4). Arguably a smoothed one-year trend fits better, but here even the notion of a structural uptrend is really in doubt. Whatever, in hard dollars dairy constitutes 29% of New Zealands export earnings, or NZD 14 billion in the year-to-January. But even an impressive 25% gain here last year couldnt offset deterioration elsewhere in the countrys balance of payments. The trade account has inched up into barely positive territory but been more than offset by ebbing FDI and (particularly) portfolio inflows. Thus New Zealands basic balance has clearly deteriorated, leaving kiwi to find support in ballooning Errors and Omissions (charts 5&6). Spare a thought for the Q4 data which come out next Tuesday.

1 The International Farm Comparison Network is an association of dairy researchers in 95 countries. See http://www.ifcndairy.org/media/downloads/Press-release-IFCN-Dairy-Report-2013.pdf 2

http://www.globaldairytrade.info/en/product-results/

________________________________________________________________________________________________________________ Deutsche Bank AG/London

11 March 2014 FX Daily: Wheeler's got bottle, kiwi can't milk it

NZD real effective exchange rate (avg = 100)

NZD/USD and US rates

Source: Deutsche Bank, Bloomberg Finance LP

Source: Deutsche Bank, Bloomberg Finance LP

NZD/USD and NZ rates, US spread

NZD/USD and New Zealands terms of trade

Source: Deutsche Bank, Bloomberg Finance LP

Source: Deutsche Bank, Bloomberg Finance LP

Long-term BoP supports ebbing

E&O attributed to derivatives and less foreign borrowing

Source: Deutsche Bank, Bloomberg Finance LP, * current a/c + FDI + portfolio flows

Source: Deutsche Bank, Bloomberg Finance LP

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Deutsche Bank AG/London