Forex Investment and Currency Trading

AUD

Policy rates rose for two months consecutively in February and March. But markets now price the next move in rates as down and this represents a significant danger for the AUD as it is starting from high levels supported primarily by attractive rate differentials.

Immediate rate cut risks shouldn’t be exaggerated. The RBA’s latest monetary policy statement was certainly more dovish, but that only made it broadly neutral as the previous stance had been clearly hawkish. There are, as the RBA said, some tentative signs of weakness in the Australian economy, with business and consumer sentiment both weakening and credit growth slowing, but they are tentative at this stage, and credit growth is still strong. For now, policy is on hold, and the market pricing of rate cuts will need further weak data for justification.

The high level of real and nominal interest rates in Australia is ultimately expected to deliver a domestic slowdown by the end of the year and create conditions for rate cuts. The Australian household sector is highly leveraged and the high level of rates will consequently have a bigger impact on Australian consumer spending than elsewhere. The credit crunch is having less impact on the financial sector than it is in the US and Europe, but is nevertheless having some impact on the funding costs of Australian banks and consequently on the cost of borrowing. This is effectively a tightening of policy.

Weakness in commodity prices is unlikely to be the prime reason behind any turn in the AUD. The key characteristic of the Australian economy is the highly leveraged household sector, and the impact of higher rates on this sector is the most likely trigger for a turn lower in interest rates and in the AUD.

For the AUD to suffer independently from weaker commodity prices would require general weakness in the world economy, and in particular in emerging markets. If this comes, it is likely to be a result of softer demand from the western consumer, feeding through gradually into slower export and investment growth in Asia. The direct impact of consumer weakness would be more crucial than the resultant commodity price weakness on the AUD. As the RBA also make clear, terms of trade are once again likely to move in the AUD’s favour this year.

NZD

The NZD was the biggest casualty of the risk reduction that accompanied the sub-prime crisis in August/September, but has held up much better in the latest sell off in high yielders. This is because interest rate spreads have moved substantially in the NZD’s favour since, and because data from New Zealand have remained strong. This may in turn be partly because the NZ data tends to lag numbers elsewhere but there are nevertheless good reasons to expect the NZ economy to perform more strongly than many others.

High food prices that are a problem for most of the western world are positive for NZ via the terms of trade. Fundamental negatives for New Zealand are well-known. The current account deficit is large at around 8% of GDP, even though growth has been modest in recent years, and the personal sector is both extremely indebted and still a negative saver. But consumer spending growth is solid despite significant rate rises from RBNZ over the last year. The driver has been increasing labour income, due largely to rising food prices, particularly milk prices. Consumer spending is strong enough to prevent the RBNZ cutting rates, and this should be enough to support the NZD against the USD in anything except a capitulating risk environment.

Still, as the highest yielder among major currencies, the NZD is clearly very risk sensitive. If the world economy continues to perform, then the Fed is effectively cutting rates on behalf of everyone else, reducing the need for rate cuts elsewhere. In this scenario there can be a lot more upside for the NZD as long as domestic frailties don’t come home to roost.

Ultimately however, a global slowdown, which we expect to be underway by mid 2008, is likely to take some toll on the New Zealand economy; and if rates do start to fall there is potential for a sharp decline in the NZD. But NZD strength in recent years to some extent reflects past undervaluation of high yielders in general and the NZD in particular. In addition, equity markets are already at historically cheap levels making further dramatic weakness less likely.