Investment Insight | New Zealand dollar benefits from a booming economy.
Understanding currencies is a critical part of investment management. Any time an investment is made outside New Zealand, an investor takes on foreign currency exposure.
The starting point for NZ Funds is that we manage money for New Zealand-based clients. Our clients’ operating currency is the New Zealand dollar; our default position is to hedge all currency exposure so that currency fluctuations do not impact the returns from investments overseas.
This doesn’t mean our clients have no exposure to foreign exchange. Instead, it means that currency exposure is an active and intentional position – and an investment in its own right. NZ Funds will take positions when we have a view that there are fundamental reasons for a change in the value of a currency.
Simply stated, a country’s currency ultimately reflects the strength and health of that economy. Over time, these changes can be significant. The New Zealand economy, for instance, is far stronger today than it was in the early 2000s and, as a result, the value of the New Zealand dollar (70 cents to the United States dollar) is well above the low (39 cents to the United States dollar) recorded in December 2000.
However, over shorter time periods different factors can dominate. This is especially the case when looking at the performance of the New Zealand dollar against the United States dollar. More often than not, this cross rate is dominated by the path of the United States dollar and what is happening in New Zealand has little impact.
Closer to home, the similarities between the New Zealand and Australian economies means the exchange rate between the countries is influenced less by what is fashionable in financial markets and more by the relative performance of the economies.
Recently the performance of these economies has diverged, which has seen the New Zealand dollar steadily appreciate against the Australian dollar.
Currently, the outlook for Australia is relatively downbeat:
• Lockdowns across a large percentage of the country are weighing on economic activity, and these are likely to continue for some time.
• Economic activity is positive but not spectacular and unemployment remains elevated at 4.90%.
• The Reserve Bank of Australia has indicated that they see a need to continue to provide economic stimulus, so interest rates are likely to stay low.
New Zealand, in contrast, is running hot:
• Economic activity is strong and accelerating – 1st Quarter GDP was 1.6%, or 6.4% annualised.
• Inflation is currently 3.3% and rising, and shortages suggest this trend will continue.
• Unemployment has returned to pre-COVID-19 lows of just 4%. Surveys suggest that employers are struggling to fill roles and in some cases are paying-up to attract staff.
The Reserve Bank of New Zealand (RBNZ) has been clear they are uncomfortable with the momentum of the economy, and that they want to take their foot off the monetary policy accelerator. It is widely expected that they will move the Official Cash Rate higher this month.
This economic divergence is reflected across three interrelated factors that NZ Funds follows: relative economic activity, relative interest rates, and relative speculative positioning. In the past, these factors have correlated with the direction of New Zealand/Australia exchange rate.
Relative economic activity
Over long timeframes, the difference in economic growth rates is important. However, as is often the case in financial markets, over shorter time periods markets are sensitive to the change in activity rather than the level of activity.
To track this, we use a series of indices published by Citigroup that measures economic surprises. These indices track whether economic data being released is below, at, or above the expected level. Currently, the indices for both New Zealand and Australia are positive as economic data has generally been better than expected.
However, New Zealand’s data has been consistently ahead of the expected level – a reflection that the economy is running hot. In the past, the relative performance of these surprise indices has had a strong correlation with the 3-month change in New Zealand/Australian exchange rate.
Relative interest rates
The level of interest rates generally is an important driver of exchange rates. This is reflected by investors moving money to countries that offer a higher yield.
Our research has identified that a 50/50 mix of 2-year wholesale interest rates and the expected 3-month bank bill (futures) one year ahead move in the same direction as the cross rate.
Recently, the change in stance by the RBNZ and the reintroduction of COVID-19 lockdowns in Australia have led to interest rates in the two countries moving in very different directions. In total, the relative interest rate move has been more than 2% in favour of New Zealand. This places significant pressure on the New Zealand dollar to head higher against the Australian dollar.
Investor positioning
The last factor we look at is investor positioning. Given the size of financial markets, the flow of money generated by financial institutions such as NZ Funds dwarfs the day-to-day flow of money required for trading goods and services. As a result, understanding how international investors are positioned is a useful indicator for the flows into and out of a currency. Currently, positioning is heavily tilted towards New Zealand which is positive for the New Zealand dollar against the Australian dollar. However, it is also a potential early warning sign that the move higher may be running out of steam, as those who were going to buy the New Zealand dollar may have already done so.
In combination, these factors suggest that the New Zealand dollar is likely to continue to gradually appreciate against the Australian dollar. NZ Funds has ensured that its Portfolios with an exposure to Australian assets are positioned for this expected move higher in the New Zealand dollar.
The starting point for NZ Funds is that we manage money for New Zealand-based clients. Our clients’ operating currency is the New Zealand dollar; our default position is to hedge all currency exposure so that currency fluctuations do not impact the returns from investments overseas.
This doesn’t mean our clients have no exposure to foreign exchange. Instead, it means that currency exposure is an active and intentional position – and an investment in its own right. NZ Funds will take positions when we have a view that there are fundamental reasons for a change in the value of a currency.
Simply stated, a country’s currency ultimately reflects the strength and health of that economy. Over time, these changes can be significant. The New Zealand economy, for instance, is far stronger today than it was in the early 2000s and, as a result, the value of the New Zealand dollar (70 cents to the United States dollar) is well above the low (39 cents to the United States dollar) recorded in December 2000.
However, over shorter time periods different factors can dominate. This is especially the case when looking at the performance of the New Zealand dollar against the United States dollar. More often than not, this cross rate is dominated by the path of the United States dollar and what is happening in New Zealand has little impact.
Closer to home, the similarities between the New Zealand and Australian economies means the exchange rate between the countries is influenced less by what is fashionable in financial markets and more by the relative performance of the economies.
Recently the performance of these economies has diverged, which has seen the New Zealand dollar steadily appreciate against the Australian dollar.
Currently, the outlook for Australia is relatively downbeat:
• Lockdowns across a large percentage of the country are weighing on economic activity, and these are likely to continue for some time.
• Economic activity is positive but not spectacular and unemployment remains elevated at 4.90%.
• The Reserve Bank of Australia has indicated that they see a need to continue to provide economic stimulus, so interest rates are likely to stay low.
New Zealand, in contrast, is running hot:
• Economic activity is strong and accelerating – 1st Quarter GDP was 1.6%, or 6.4% annualised.
• Inflation is currently 3.3% and rising, and shortages suggest this trend will continue.
• Unemployment has returned to pre-COVID-19 lows of just 4%. Surveys suggest that employers are struggling to fill roles and in some cases are paying-up to attract staff.
The Reserve Bank of New Zealand (RBNZ) has been clear they are uncomfortable with the momentum of the economy, and that they want to take their foot off the monetary policy accelerator. It is widely expected that they will move the Official Cash Rate higher this month.
This economic divergence is reflected across three interrelated factors that NZ Funds follows: relative economic activity, relative interest rates, and relative speculative positioning. In the past, these factors have correlated with the direction of New Zealand/Australia exchange rate.
Relative economic activity
Over long timeframes, the difference in economic growth rates is important. However, as is often the case in financial markets, over shorter time periods markets are sensitive to the change in activity rather than the level of activity.
To track this, we use a series of indices published by Citigroup that measures economic surprises. These indices track whether economic data being released is below, at, or above the expected level. Currently, the indices for both New Zealand and Australia are positive as economic data has generally been better than expected.
However, New Zealand’s data has been consistently ahead of the expected level – a reflection that the economy is running hot. In the past, the relative performance of these surprise indices has had a strong correlation with the 3-month change in New Zealand/Australian exchange rate.
Relative interest rates
The level of interest rates generally is an important driver of exchange rates. This is reflected by investors moving money to countries that offer a higher yield.
Our research has identified that a 50/50 mix of 2-year wholesale interest rates and the expected 3-month bank bill (futures) one year ahead move in the same direction as the cross rate.
Recently, the change in stance by the RBNZ and the reintroduction of COVID-19 lockdowns in Australia have led to interest rates in the two countries moving in very different directions. In total, the relative interest rate move has been more than 2% in favour of New Zealand. This places significant pressure on the New Zealand dollar to head higher against the Australian dollar.
Investor positioning
The last factor we look at is investor positioning. Given the size of financial markets, the flow of money generated by financial institutions such as NZ Funds dwarfs the day-to-day flow of money required for trading goods and services. As a result, understanding how international investors are positioned is a useful indicator for the flows into and out of a currency. Currently, positioning is heavily tilted towards New Zealand which is positive for the New Zealand dollar against the Australian dollar. However, it is also a potential early warning sign that the move higher may be running out of steam, as those who were going to buy the New Zealand dollar may have already done so.
In combination, these factors suggest that the New Zealand dollar is likely to continue to gradually appreciate against the Australian dollar. NZ Funds has ensured that its Portfolios with an exposure to Australian assets are positioned for this expected move higher in the New Zealand dollar.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Mark Brooks is Portfolio Manager for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Mark's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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