What is it about the Kiwi dollar?
The swings and roundabouts in the New Zealand dollar were a dominating factor for businesses over 2009. The New Zealand dollar started the year in free-fall, dropping 15% over January. But after themonetary floodgates opened, the kiwi staged a massive 44% rally over the nextseven months.
It is often said that short-term currencymovements are nearly unpredictable. But that is not the quite the same thingas saying its movements are unexplainable, after the fact. And in actuality,the kiwi’s movements this year were well explained by a simple model comprisingjust three factors.
What does this mean exactly? Over thelast four years (ie both before the credit crunch and after it), the kiwi’sbehaviour has been consistently governed by its relationship to three factors. Once these are accounted for, the kiwi has rarely done anything surprising. Tophrase it differently, the kiwi has rarely been over or under valued by thedefinition of the model (of course there are many possible models, a subject weshall return to below).
There is nothing especially controversialabout our choice of factors.
- The first factor is the interest rate gapbetween New Zealand and the US. This gap captures expectations of differentgrowth rates and inflation rates between the two countries and is a proxy forthe carry-trade influence on the currency. When the rate gap is larger, the New Zealand dollar is higher.
- The second factor is the spread betweenhigh-yield (junk) bonds and government bonds in the US, which captures marketrisk aversion. When risk aversion is higher, investors demand greatercompensation for the risk of default (in the case of currencies, this means acheaper starting point for the currency). In a credit crisis, New Zealand is more likely to come unstuck and experience a currency run. Spreads onhigh-yield junk bonds are a proxy for this (and the fact that NZ Inc isaccorded junk bond status should be a sobering thought!). When the spread issmaller, the New Zealand dollar is higher.
- The third factor is commodity prices, which areeffectively the key determinant of earnings for NZ Inc’s tradable sector. Higher commodity prices suggest that a stronger dollar can be justified overthe long-term. When commodity prices are higher, the New Zealand dollar is higher.
One implication of this model is that thekiwi could be quite successfully predicted if all of those factors could besuccessfully predicted. In practice, this task is not an easy one. In January2009, with a global financial system seemingly on the verge of total collapse,who would have guessed that junk bonds would be trading normally within ayear? Or that despite the worst global recession in 50 years, commodity priceswould rally strongly?
We can look at the kiwi’s 44% recoveryover 2009 through the lens of the model. When we do, it emerges that there isnothing unusual about the currency’s reaction, a result that holds even if themodel was calibrated only using data available up until the end of 2008.
All three factors have contributed to theclimb. Commodity prices (contribution +5.0c) have lifted over the last sixmonths as the outlook for global growth, especially in the developing world,has undergone a marked improvement. New Zealand’s interest rate gap(contribution +5.7c) has widened significantly as it became clear that the New Zealand economy was in a relatively strong position and the Reserve Bank would raiseinterest rates more than the US Federal Reserve in 2010. But the mostsignificant impact on the currency has come from the healing of the creditcrisis, and the corresponding reduction in risk aversion (contribution+10.8c). Investors have poured back into risky assets, pushing up prices(which manifests as a higher New Zealand dollar and lower junk bond yields).
The sharp change in risk aversion is mostapparent in Graph 8.3, which plots the factors over time. The spread on junkbonds fell from 15% in March 2009 to just over 5% at the end of the year â€“ alevel consistent with a completely normal credit market. And at almost exactlythe same time, commodity prices reversed direction, and New Zealand interest rates started to climb. All three factors were pulling the dollarhigher in unison.
This confluence of drivers is notentirely unheard of â€“ financial variables tend to be correlated with eachother. This tendency can make it hard to isolate cause and effect, or toseparate the relevant factors from the irrelevant ones. For example, worldstock markets do not appear in this model, despite the clear correlation withthe currency on a monthly basis. In this instance, interest rates, riskaversion, and commodity prices seem to capture all the relevant information forthe New Zealand dollar that is available in the movements of the S&P500.
Where to in 2010
All financial models come with thestandard disclaimer: future performance may be less thrilling than in thepast. One warning sign is that the relationship described above does not fitthe data as well over longer time periods. This lack of fit may mean that weare not witnessing a true relationship, or that the currency’s relationship toother variables varies over time â€“ the market’s attention can be fickle.
Clearly there are factors that westrongly believe do matter for the currency at certain times, or over longerperiods, even if they weren’t as relevant in the last four years. TheAustralian dollar has a strong influence on the New Zealand dollar, althoughincluding it in a model just begs the question of what explains the Australiandollar. Over the long-term, economists also believe that fundamental factorsguide exchange rates. Namely, the currency needs to be at a level where thecurrent account deficit is sustainable â€“ a dubious proposition at currentlevels in New Zealand. Purchasing power parity also plays a part â€“ a basket oftradable goods should cost roughly the same in every country once exchangerates are allowed for.
But let’s assume this model holds foranother year. Our first observation would be that risk aversion has almost returnedto normal, and that, even in a climate of very easy monetary policy, we seelittle room for it to fall further. So there is little remaining support forthe dollar from this avenue.
The interest rate gap is harder topredict. Current market rates already price in tightening in both New Zealand and the United States, and the interest rate gap between the two is already aboveaverage. But our view is that New Zealand, unlike the United States, has some risk of an overheated housing market and an inflation problem bythe end of 2010.
Finally, commodity prices are not goingto sustain their hot streak of the last six months, but prices will keep risingon the back of strong economic recoveries in developing economies. Lowinterest rates in the major economies will be a second source of stimulus.
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