Commodity Crisis Pressures New Zealand Dollar

• Tumbling Milk Prices Force RBNZ To Drop Rates
• Global Commodity Deflation Impacting Export Economy
• NZDUSD Facing Further Downside in Response to Deteriorating External Conditions

What started as commodity deflation has turned into a full blown commodity crisis as a tidal wave of bad news impacts the outlook.  Comments from China about an expected drop in raw material imports and a startling amount of devaluation feeding the current leg of the global currency war have contributed to the recent carnage in the energy complex and base metals. However, agricultural commodities have not proved immune and are largely driven by many of the same factors. New Zealand in particular has been one of the harder hit regions in the Asia-Pacific region due to its large exposure to the Chinese economy and slipping exports. While the Central Bank has maintained an accommodative stance to combat the downturn, more action will be needed to keep the economy afloat.

RBNZ Eases

In general, the New Zealand economy is fairly insulated from global economic developments owing to its particularly stable predisposition.  The nation of 4.4 million is approximately the size of the United Kingdom and is known in particular for sheep outnumbering humans by a wide margin and exports of milk solids.  However, commodity deflation has not left milk out of the equation. Crop yields across the globe are forecast to be stronger this year, contributing to a price drop in agricultural commodities. The price of milk solids in particular has fallen by over 40% versus the figures from the prior year.  Since 2013, around the same time that gold prices started rapidly falling, milk solid prices have plummeted.  Contributing to the downside was another case of oversupply with production outstripping demand by a wide margin. 

A result of the drop in milk solid prices has been pressure on inflation measures which have also trailed lower. The most recent annualized inflation figure printed at 0.40% with quarterly consumer prices experiencing rapid disinflation with the latest figure at 0.40% while the prior two figures printed in deflationary territory. With inflation tumbling and commodity prices sharpening the dive down, the Reserve Bank of New Zealand has been forced to act on a number of occasions to accommodate the economy with increased monetary stimulus.  So far, activities has solely included interest rate cuts in a bid to improve lending conditions and weaken the New Zealand dollar.  In the last year, the Central Bank has slashed interest rates by 75 basis points to 2.75%. The New Zealand dollar has largely reflected these measures with a steep drop in the local currency.

NZDUSD Crumbles on Outlook

While unemployment has accelerated in recent months, according to the latest statement from RBNZ Governor Graeme Wheeler, there are factors that are supportive of continued growth in the economy as it adjusts to a weaker New Zealand dollar. Strong immigration, booming construction activity, and tourism continue to buoy the economy in these times of turmoil as exporters adjust to new pricing realities. With the rapid amount of commodity deflation in mind, the Central Bank continues to maintain its accommodative stance despite the fact that reducing interest rates further could stoke a housing bubble in certain cities such as Auckland. Headline inflation remains below the targeted 1-3%, highlighting the difficulties ahead for the Central Bank as further interest rate declines are anticipated. 

The New Zealand dollar was trading as high as 0.8843 versus the US dollar back in 2014 before hurtling lower towards current levels near 0.6350, or a near 30% correction lower in the pair in just over a year. While most developed economies have promised not to engage in outright devaluation of currencies, countries like Australia and New Zealand which boast higher interest rates are able to use monetary policies to influence exchange rates.  Other tools such as jawboning about the overvaluation of the local currency can help, but is not necessarily as effective. At a certain point, market participants will show that actions speak louder than words, and current forecasts show that rates are expected to decline to as low as 2.00% by the end of the first quarter of 2016, highlighting the potential for further losses in NZDUSD. 

Click on picture to enlarge

Although the currency pair looks near a turning point, the bias remains to the downside with commodity prices showing further room to fall.  A retest of recent multi-year lows at 0.6196 is extremely likely in the near-term, necessitating Put positions to take advantage of the prevailing longer-term downtrend targeting 2009 levels at 0.5980. However, should the current price action begin to signal a turnaround in the pair and correction to the upside following months of momentum lower, the key resistance level to monitor on the upside is 0.6466. A move above this level would necessitate Call positions to take advantage of a rally towards 0.6683.

Conclusion

With the growing evidence of a prolonged downturn in commodity prices at every corner combined with a weak global outlook, the RBNZ is forecast to continue easing monetary policy to protect the New Zealand economy. A bounce in milk solid prices would certainly help the outlook, but based on the current levels of dairy overproduction and weaker demand, a near-term rebound in the export economy is not likely, hence the need to drop interest rates further to shield the economy. While New Zealand might boast some of the strongest growth amongst advanced economies, risks generally remain to the downside, necessitating the assessment of Put positions on upticks to take advantage of expectations of further policy accommodation. While there might be a short-term technical rebound where Call positions might prove advantageous, fighting the longer-term trend lower might prove exceptionally risky for investors.