The NZD/USD currency pair, which expresses the value of the New Zealand dollar in terms of the U.S. dollar, has been pushing higher in recent times. The 0.68 handle, which the current market price for NZD/USD is just underneath, appears to align well with several other points of support and resistance over the past three years (see daily candlestick chart below).
In mid-2017, this was found as support. In June 2018, the support was broken; later, from August 2018 through to July 2019 (and arguably even December 2019), several more attempts were made. NZD currently trades at the 0.68 level once again, and the question is whether we will see a further break to the upside.
Regardless of ultimate outcome, it is probable that the pair will trade for at least a few weeks in this area (it was months in the case of August 2018 to April 2019). That is, any short-term volatility notwithstanding. I have held previously that the impetus here favors upside, on the basis of a combination of improving terms of trade (favoring NZD over USD), generally positive risk sentiment (favoring commodity currencies such as NZD), and broader USD weakness (as markets have repriced EUR/USD higher, among other short-USD crosses).
We should remind ourselves that global rates are no longer what they used to be. Therefore, no true rates-driven impetus is afforded to G10 FX pairs at the moment. The Reserve Bank of New Zealand’s short-term rate of +0.25% is technically higher than the midpoint of the U.S. Federal Reserve’s target range of 0.00-0.25%, but both rates are effectively set at the ‘zero lower bound’. Further, Federal Reserve officials expect to keep rates at near zero through to at least 2023. The RBNZ is likely to follow the Fed in this non-journey.
Therefore, other factors matter. As referenced previously, terms of trade (the ratio between export prices and import prices) usually correlate positively with currency strength, provided that we see specific outperformance. The chart below illustrates NZD terms of trade have outperformed USD terms of trade this year.
(Source: Trading Economics)
This is something to keep an eye on. But if we think about the equation for FX price changes (or fair-value changes), and if one of the traditional factors includes interest rate spreads, the absence of any real spreads now necessarily places more weight on other factors like terms of trade.
Additionally, longer-term Purchasing Power Parity models enable us to assess the relative purchasing power of currencies, and compare the implied fair values here to present market prices. I construct a basic PPP chart using OECD model data below. The red line indicates fair value, the black line illustrates NZD/USD price action, and the bands reflect a 30% rolling delta from the annual fair value estimate (providing us with longer-term context around price).
My immediate observation to the chart above is that every time since the year 2000 that NZD/USD approached its estimated fair value (based on the OECD’s PPP model), the pair broke above the line. From 2016 through to 2019, fair value has been estimated at approximately 0.69. If we assume not too much deviation from this figure in 2020, it is a fairly safe bet that NZD will break above 0.69 in the next twelve months, and probably above the 0.70 handle.
NZD has fallen in and out of favor. Some currencies enjoy consistent premiums or discounts to USD (and/or other currencies). Yet NZD appears able to trade at both longer-term discounts and premiums, depending on where we are in the cycle and wherever capital flows show their preference. In 2008/09, NZD crashed as the Great Recession punished perceptibly riskier commodity currencies (we saw a similar but far smaller episode of the same earlier this year). In good or better times (such as from 2010 through 2014), NZD has rallied (albeit in a fairly volatile fashion).
After the first quarter of this year, NZD has staged another rally, and therefore the current trend favors further upside in line with improving terms of trade differentials and historical behavior with respect to our PPP model. Positive risk sentiment following significant monetary policy interventions globally (to include the slashing of U.S. rates to practically zero) will help to support NZD trading at a premium to USD in 2020.
The bond market’s longer-term perspective on U.S. rates versus New Zealand still seems to favor USD over NZD (see the 10-year yields below).
However, we are seeing improvements in the steepness of both the U.S. and New Zealand curves (longer-term rates are rising relative to shorter-term rates). While we are probably going to see some yield curve management from major central banks going forward (still considered unconventional monetary policy, even in a world where negative rates have existed for years), at the moment this is fairly constructive for USD weakness. The U.S. dollar is still the world’s principal reserve currency, and steeper yield curves in combination with positive sentiment across risk assets generally supports a weaker USD (which usually rallies as a safe haven in the case of inverting yield curves and/or negative risk sentiment).
The important macroeconomic indicators of growth and inflation also matter now more than ever. New Zealand‘s economy shrunk by 12.4% in Q2 2020, as compared to the United States which shrunk by 9.1%. This also follows Q1 2020 in which the U.S. also out-performed New Zealand with an annual GDP growth rate of +0.3% (versus New Zealand’s negative -0.1%). While the United States’ inflation rate is rising (1.3% in August 2020; see below), it is still averaging at a lower level than the inflation rates we are seeing from New Zealand.
(Source: Trading Economics)
New Zealand’s annual inflation rate in Q2 2020 was +1.5%, and was as high as +2.5% in Q1 2020.
(Source: Trading Economics)
With higher inflation rates in New Zealand relative to the United States, and with practically the same interest rates, USD probably has a higher “real yield” (on an inflation adjusted basis), although the fact that USD remains very liquid in funding markets does mean that USD and NZD are almost tied. Every LIBOR tenor from three-month LIBOR through to the overnight rate is currently below the 25 basis-point ‘upper limit’ of the Fed’s target (see below).
As previously indicated, my conclusion is that we will see further upside from NZD/USD due to an improving terms of trade differential, positive risk sentiment, a supportive PPP model (which currently places NZD at a probable discount to USD), improving yield curves, a liquid U.S. dollar, and almost even ‘real yields’.
We do, however, want to see a bounce-back from New Zealand in the third and fourth quarters; if the country continues to drag behind the United States, we would need to reassess this position. Capital typically flows to higher growth rates (adjusted for inflation), and at the moment, United States appears to be in the lead. Due to significant fiscal interventions in response to the COVID-19 pandemic, and differences in calculating and reporting unemployment, I would argue current unemployment rates are not incredibly informational. Yet this is another macroeconomic indicator that will likely become very important as we assess NZD/USD into 2021.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.