Westpac: AUD/NZD Outlook

AUD/NZD past three months: Relative commodity prices have been arguing for stronger AUD/NZD for months but it took the RBNZ’s meeting this month to fuel a break of 1.06 for the first time since November. The RBNZ remains upbeat on New Zealand’s economy – with good reason – but Governor Wheeler again warned about international risks (including US protectionism) and chided markets for pricing in a rate hike this year. AUD/NZD has rallied 3 cents since this statement. • But fair value estimates were already above 1.10 even when markets were fully priced for an RBNZ rate hike by Nov 2017. AUD/NZD has diverged notably from yield spreads since about mid-2016. • While the persistence of AUD/NZD below our fair value estimates (now 1.12-1.13) argues for patience, it seems there is still plenty of upside scope for the pair. With support near term from iron ore and coal prices outperforming dairy, AUD/NZD should break important resistance at 1.0765. This would place the pair on track for substantial further gains, with a multi-month target of 1.10.

AUD/NZD trading ranges since 1985 NZD float:
AUD/NZD remains a long way below its long term average though the 1.05- 1.10 range accounts for a solid 13% of daily closes since the NZD float in 1985. • It is now 3 ½ years since AUD/NZD traded above 1.20 (June 2013) so this distribution continues to shift gradually lower.

AUD/NZD versus interest rate differentials: The 2 year AU-NZ swap spread remains short of the April 2016 levels near 0%, just ahead of Australia’s low Q1 2016 CPI and then the RBA May rate cut. But it remains a long way above the Q2 2015 lows when AUD/NZD was below 1.01. The spread has been roughly range-bound in recent months. • While AUD/NZD followed the gyrations of RBA vs RBNZ monetary policy in H1 2016, the relationship since mid-2016 has been poor. AUD/NZD remains well below the levels indicated by yield spreads. • This divergence is a key factor in our AUD/NZD fair value estimate’s persistence above spot and our ongoing inclination to buy dips in the pair.

RBA cash rate: market pricing: The RBA held the cash rate at 1.5% in February and maintained a neutral outlook in its statement. This was fully expected. • Perhaps most notable in the statement – later reinforced in the quarterly SoMP – was a more upbeat view of the global economy: “The improvement in the global economy has contributed to higher commodity prices, which are providing a boost to Australia’s national income.” GDP growth is expected to rebound after the weak Q3 reading. • Westpac expects that the labour market – rather than inflation – will be key to whether there is a rate cut in 2017. Our base case is that the cash rate remains at 1.5% throughout both 2017 and 2018. We see risks to this view skewed more to a rate cut than to a hike, as growth in 2018 could disappoint. • Markets price only a small risk (about 10%) of a cut by June 2017 and then toy with the idea of a rate rise by year end (15% chance).


RBNZ cash rate: market pricing: At its February interest rate decision, the RBNZ kept the OCR on hold at 1.75% as fully expected. • Our NZ Economics team notes that it also signalled that the OCR is likely to remain on hold for some time. The tone of the accompanying policy statement was very neutral. • The Bank’s forecasts for the OCR have been nudged up very slightly over the next few years and now curve up just a little in late 2019/ early 2020. This doesn’t suggest that any rate hikes are imminent. Rather, it reflects that with the economy growing at a firm pace and inflation gradually climbing, the risks for the OCR have become more balanced. • With inflation expected to lift only gradually, we see a very low probability that recent OCR cuts will be reversed any time soon. • Market pricing for a rate hike by end- 2017 had been 100% in the early weeks of 2017 but is now back to about 50/50.

AUD/NZD versus relative commodity proxy:  The ratio of Australia’s commodity prices to a similar measure weighted by New Zealand’s key commodity exports has rallied strongly over the past 12 months. • The surge in the prices of Australia’s top 2 exports – iron ore and coal – was a key surprise for AUD in 2016. In the case of coal, Chinese government steps to close unprofitable mines and reduce pollution played a larger role than expected in supporting volumes and prices of imported coal. • More recently, China has blocked coal imports from North Korea as part of UN sanctions, further reducing supply. There is also considerable attention on infrastructure spending plans, including a 50% boost for Xinjiang. Iron ore prices have hit highs since 2013, though doubts remain over how sustainable the rally will be. • For NZ, whole milk powder prices have eased to 2 month lows, but are still 55% higher than mid-2016. • Overall, commodity prices support the message from relative interest rates that AUD/NZD is undervalued.

AUD/NZD currently 5c below fair value: Our short term fair value estimate of AUD/NZD has not been below 1.10 since July 2016 and rose as high as 1.15 in November before easing back to 1.13 by February 2017, cooling slightly in line with coking coal prices either side of year-end. • The gap between the spot rate and 1.13 fair value is a function of both yield spreads (see chart on page 4) and relative commodity prices. • This is key to our expectation that AUD/NZD will trend higher in coming months, though we don’t expect such a wide gap to be closed any time soon. Fair value estimates are always a simplification of a currency pair’s fundamental drivers, so deviations from the spot rate can persist for some time. • As the chart shows, the current phase of AUD/NZD undervaluation is both unusually large and sustained, though it has narrowed since December.

Australian data pulse: Australia’s data pulse (% of data stronger than the previous release in a rolling 8 week window) has recovered to around 50%. • The pulse appears to be consistent with an economy that – notwithstanding the contraction in GDP in Q3 2016 – is growing at a moderate pace. • Employment data is mixed but the residential construction pipeline remains very large and the outlook for exports has brightened considerably in recent months, with the Dec trade surplus a record A$3.5bn. There should be more surpluses in coming months.

NZ data pulse: The NZ data pulse has been choppy either side of 50% so far in 2017. In terms of key data, Q4 inflation printed on the firm side but the unemployment rate rose back above 5%. • This series is somewhat prone to volatility given that New Zealand’s data can be thin at times, with e.g. employment a quarterly rather than monthly release

Speculative net AUD positions on IMM/CME: Leveraged funds were heavily long AUD on US election day (8 November), with a net long exceeding 50k contracts (AUD5bn face value). The unwind began after the election and continued almost without interruption into 2017. By 10 January, these funds were net short -20k, their most bearish stance since February 2016. • But since then, specs have swung back to an increasingly bullish AUD stance. So specs were on board as AUD/USD probed above 0.77 for the first time since November. • Asset managers meanwhile had been sitting on modest net long AUD positions ahead of the US election, joined the broadly bullish USD mood for a few weeks but then ticked back to small net long AUD/USD in the early weeks of 2017.

Speculative net NZD positions via futures: According to the CFTC data on positioning in FX futures on the Chicago Mercantile Exchange, leveraged funds are very bullish NZD. The 30.3k net long position on 6 Sep 2016 was the largest in the history of this series and by 14 February 2017, was back to 30.0k. • Asset manager positioning is reported by the CFTC as persistently short however, indeed every week since Jan 2015. We are reluctant to place much weight on this. • If futures markets are similar to the stance in the spot market, then speculative positioning seems slightly bullish for AUD/NZD (moderate AUD longs vs record NZD longs). But there is considerable doubt over how representative the data is for the kiwi at least, given e.g. its small scale.

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