Fran O'Sullivan and Alexander Speirs: Dairy price drop shocker

It's looking like a cow of a season is on the way.

$3b loss puts pressure on economy, currency and farmers who hold $32b in debt.

All the smart eyes will be on the Reserve Bank this morning to see if the softening in global dairy prices has persuaded Governor Graeme Wheeler that it's time to insert a pause into the current interest hiking cycle.

Last week's Global Dairy Trade auction was a shocker.

Sure, auction prices have been dropping since February as the big buyers out of China shortened up their order books as they dealt with an oversupply of inventory as Chinese consumers peg back a little.

But another 9 per cent off the headline rate was just the rumble that NZ dairy farmers didn't need. All up, prices are off by more than one-third this year. That has consequences.

Whether Wheeler lifts interest rates again -- and there are mixed views from our leading banking economists as to just when the pause will take place (today or at the next official cash rate decision point) -- will have a considerable effect on dairy farmer pockets.

Those dairy farmers face a triple whammy.

First -- there are widespread expectations Fonterra will slash its farm-gate payout price of $7 per kilogram of milk solids for next season down to $6-$6.25 per kg. If it's $6 that would be a 28 per cent reduction from last season's $8.40 price.

Here's the thing -- at last year's National Fieldays, Dairy NZ chief executive Tim Mackle said analysis showed a sizeable proportion of farmers needed to earn at least $6 per kilogram just to cover their farming essentials -- primary expenses and servicing interest payments. That's before any personal drawings or mortgage payments are taken into the equation.

When Fonterra slashes prices, it will be felt in farmers' pockets by reducing their incomes $3 billion in total, according to ANZ estimates, if it goes down to $6/kg.

Second -- between them, those dairy farmers account for $32 billion worth of debt. The Reserve Bank says close to 70 per cent of that debt is on floating mortgage rates, which leaves farmers especially exposed to any changes to the OCR. If rates are hiked again today (and particularly at the next OCR date) don't expect the banks to hold back long before flowing through to floating rates.

Third -- high interest rates suck in international investors and put upwards pressure on the kiwi dollar/greenback rate -- with the international dairy trade priced in US dollars that could also have a negative effect in reducing the revenue back to Fonterra.

We've had a good look at some of the analysis out there.

One of the most insightful analysts is Sean Keane of Triple T Consulting based in Hong Kong.

Keane delved behind the headline price index which is how the Global Dairy Trade auctions are usually reported by media. While that tumbled by another 8.9 per cent, extending a steady string of losses, there are other factors at play.

Here's Keane: "The important Whole Milk Powder price index also fell by a larger 10.9 per cent. Few people expected to see prices drop by anything like these amounts.

"The Reserve Bank noted in the June Monetary Policy Statement that they expected to see a 27 per cent fall in dairy prices during 2014, noting the possibility of further decreases.

"At the time of the Reserve Bank's June forecasts, dairy prices were already off by about 25 per cent from their peak levels, and the bank appeared to be signalling at that time that it didn't expect prices to fall much further.

"It's worth noting that in June, whole milk powder was trading around $3500 per metric tonne. In last week's auction, the price was down to just over $3000.

"It looks therefore like prices are now around 14 per cent lower than the bank previously expected, while the trade weighted index was around 2.5 per cent stronger than the RBNZ assumed in June. The desire for a lower currency is clearly understandable given these divergent trends."

Most banking economists predict the Reserve Bank is unlikely to err from its stay-the-course approach this week. But a more cautious, follow-the-numbers approach is almost certain to follow. A combination of falling export commodity prices, a high dollar and tepid inflation is far from a long-term recipe for success -- but an immediate diversion from what has been a well-communicated plan from the outset could also do more harm than good.

But an immediate diversion from what has been a well communicated plan from the outset could also do more harm than good in other exposed sectors like residential housing where the governor has been trying to stop a runaway boom.