Andrew Gawith: Kiwi's wild ride not totally random

Opinion

What is it about the kiwi dollar? For firms in the tradeable sector, watching the currency brings the occupational hazard of whiplash.

The New Zealand dollar started last year in free-fall, dropping 15 per cent over January. But after central banks opened the monetary floodgates in March, the kiwi staged a huge 45 per cent rally over the next seven months.

There is a good deal of truth to the notion that short-term currency movements are unpredictable. But that is not quite the same as saying the kiwi's movements are inexplicable.

In fact, the kiwi's movements over the year were well explained by a simple, three-factor model.

What does this mean exactly? Over the past four years (ie, before the credit crunch and after it), the kiwi's behaviour has been consistently governed by its relationship to three factors.

Once these are accounted for, the kiwi's movements have rarely surprised.

The three factors that are particularly significant are the usual suspects:

1. The interest rate gap between New Zealand and the United States - when the rate gap is larger, the New Zealand dollar is higher.

2. The spread between high-yield (junk) bonds and government bonds in the US - when the spread is smaller, the dollar is higher. This reflects risk aversion, and when risk aversion is higher, investors demand greater compensation for the risk of default. (The fact that New Zealand Inc is accorded junk bond status by market reactions is a sobering thought.)

3. Commodity prices - when commodity prices rise so does the dollar. Commodity prices remain the key determinant of New Zealand's foreign earnings.

Higher commodity prices suggest that a stronger dollar can be justified over the long term.

One implication of this model is that future movements in the dollar could be successfully predicted if all we had to do was make accurate forecasts of the above three factors.

In practice, this is still no easy task. In January of 2009, in a world apparently on the verge of a giant financial market meltdown, who would have guessed that junk bonds would be trading normally within a year? Or that despite the worst global recession in 50 years, commodity prices would rally strongly?

Let's focus on the kiwi's startling 45 per cent recovery over last year - up 22c from its low-point - through the lens of the model. Commodity prices have lifted over the past six months as the outlook for global growth, especially in the developing world, has undergone a marked improvement.

New Zealand's interest rate gap has widened greatly as it became clear that the New Zealand economy was in a relatively strong position and the Reserve Bank of New Zealand would raise interest rates more than the US Federal Reserve this year.

But the most significant impact on the currency has come from the healing of the credit crisis, and the corresponding reduction in risk aversion . Investors have poured back into risk assets, pushing up prices (which translates into a higher dollar, and lower junk bond yields).

The spread on junk bonds has fallen from 15 per cent in March to just over 5 per cent - a level consistent with a completely normal credit market. And at almost exactly the same time, commodity prices reversed direction, and New Zealand interest rates started to climb. All three factors pulled the dollar higher in unison.

All financial models come with the standard disclaimer: future performance may be less thrilling than in the past. And the model excludes long-run dynamics: the currency needs to be at a level where the current account deficit is sustainable - a dubious proposition given where the dollar is currently trading and the still relatively large deficit.

But assuming this three-factor model performs well for another year, where is the kiwi heading?

First, measures of risk aversion have almost returned to normal and that, even in a climate of very easy monetary policy, means there is little room for it to fall further so soon after a major financial crisis. So there is little remaining support for the dollar from this source.

The interest rates gap is harder to predict (the model uses three-year interest rates). Current market rates already price in tightening in New Zealand and the US, and the rate gap between the two is high by historical standards. Nevertheless New Zealand is at real risk of an overheated housing market and an inflation problem by the year's end. The risk here for the kiwi lies on the upside.

Finally, commodity prices are not going to sustain their hot streak of the past six months, but prices will keep rising on the back of strong economic recoveries in developing economies.

Low interest rates in the major economies will be a second source of stimulus for commodities.

Two out of three add up to a currency that will struggle to fall out of bed this year, and may well climb to 80c against the US dollar by mid-2010.

* Andrew Gawith is a director of Gareth Morgan Investments. www.garethmorgan.com