Forex Investment and Currency Trading

A number of short term drivers that have increased the NZD bearishness. Last week’s GDP data confirmed that the economy shrank in Q1. And this was not a one off. There was widespread weakness across the primary and manufacturing sectors and parts of the services sector, as the initial effects of the drought, the housing market correction, and a major squeeze on household budgets start showing up in the national accounts data. The already high chance of economic recession just took a step higher. Indicators suggest that Q2 will be worse than Q1. That should be good enough reason for the NZ$ to weaken.

The bearishness also goes much deeper than just worrying about the potential impact of the recession on the NZ$. The retail margin traders are ignoring the rapid slowdown in the NZ economy and are therefore at risk of being caught out when the RBNZ starts to cut rates. Japanese demand for foreign yield will wane, especially if the YEN strengthens in the months ahead - which looks to be a reasonable bet. When yield spreads narrow further - as will happen when the RBNZ cuts rates - demand for NZ$ uridashi and Eurokiwi will drop off even further. This will probably all happen as maturities rise. All up, the NZ$ is likely to experience a sharp move lower in the third quarter. And arguably the RBNZ sees similar risks - they see “a  significant possibility that the exchange rate falls faster and further than [they] have assumed” and that “weak economic data may lead to a more rapid and pronounced currency depreciation” (RBNZ June MPS)

So how would we play this upcoming move lower in the NZ$. Given that this involves being short the NZ$ versus a basket of currencies, there is a natural hedge here. The basket comprises just 32% USD, so even though we are told to be short the US$ right now, the US$ long is more than offset by other currencies. So upside in the NZ TWI should be limited. It is expected to see a good deal of nervousness in the NZ$ in the immediate run up to the July OCR (July 24). This will arguably be accentuated by the combination of retail sales and CPI the week before (July 14 and 15). We should expect to see some strength in the NZ$ into the CPI data given the very obvious risks. This would present the ideal opportunity to sell the NZ$. With volatility settling back, option plays over the July 15-24 are becoming attractive. For instance, a 1 month 0.7500 NZD/USD put would cost around 0.94% of NZD (reference 0.7615). However, by adding a partial knock out at 0.7500 to July 14 would reduce the cost to just 0.215% of NZD. While this may sound aggressive, partial barriers give the ability to structure attractive risk reward trades into the OCR. Finally, other cross trades that appear very attractive at the moment are NZD/CHF and NZD/CAD. NZD/ CAD looks very expensive above 0.7800.