For global commodity markets, the start to 2017 has been resoundingly positive, with expectations of rising inflation contributing to an upward price shift. However, we may soon see a number of cracks appearing - with potentially critical consequences for our domestic economy.

While a lower New Zealand dollar will provide a significant boost to our export sector, the benefits of a lower kiwi are unlikely to offset the economic "drag" we will no doubt see should dairy prices continue to drop.

The "headline" dairy auction at the beginning of this month resulted in a 6.3 per cent reduction in average prices, and a significant fall in both whole milk powder (down 12.4 per cent) and skim milk powder (15.5 per cent). So, while demand is up relative to this time last year, it would appear that an increase in inventories has put a stop to any momentum that had previously been built.

Although the outcome of one auction doesn't indicate a trend, support for commodity prices will be monitored very closely by the Reserve Bank, as the dairy industry attempts to reduce debt following the trying time that dairy farmers have experienced of late.

Advertisement

This shift in milk prices is not an isolated incident within commodity markets, with oil once again trading below US$50 per barrel. Data from Opec suggests this is due to Saudi Arabia reducing its production costs by a third, coupled with growing US inventories - further highlighting an inability for commodity markets to effectively manage supply side responses.

The price movement has coincided with a counter-trend shift in the NZ dollar, which at the time of writing, is a full 2c lower compared to the beginning of March, against both the US and Australian dollar.

The Reserve Bank has lamented the stubbornly high kiwi for some time, with the end of the easing cycle for interest rates hinged on a weaker domestic currency. Should this downward adjustment continue, we would expect to see an inflationary reaction from our tradeable sector, and a subsequent boost for New Zealand exporters.

However, the path of inflation does not appear to be that simple - particularly given a decided lack of evidence for significant price increases, outside of the housing sector. It's likely that an increase in tradeable inflation, in the absence of a rebound in dairy prices, will not be as advantageous for the domestic economy as many believe.

Global demand for commodities will continue to be a key driver for inflationary outcomes in 2017. Domestically, the duration of cyclical commodity support, coupled with the strength of our currency, will have the greatest impact on businesses' and households' ability to reduce debt.

With household debt at increasingly high levels, imported inflation and increasing interest rates would provide material headwinds for both economic growth and household confidence levels. Although the drop in the value of the NZ dollar may provide some short term relief for exporters, this is unlikely to be as effective if demand for our exports is declining, against a global backdrop of rising inventory levels.

- Mark Fowler is head of fixed income at Hobson Wealth Partners. This article does not consider objectives or situation of any particular investor. It should not be construed as a solicitation to buy or sell any security or product.