Tuesday, June 21, 2011

Is the New Zealand Dollar Over-Valued?

Commentary by Jason Wong, Head of Investment Strategy

The NZ dollar recently reached $US0.83, a level not seen since 1981, when Robert Muldoon was still Prime Minister, the All Whites had just qualified for their first World Cup, and Hudson and Halls were deemed to be the best television entertainers. When measured in real terms and on a basket of currencies (the same weights as the MSCI index), NZ’s real exchange rate reached a record high. So where to from here?

It is tempting to argue that the NZ dollar is “over-valued” and therefore must fall. We recall hearing the expression “the NZ dollar is over-valued” back in 2004 when the currency first breached the $US0.70 mark after a period of weakness following the bursting of the tech bubble. Economists, politicians, central bankers and media have been, and still are, running the same line. So is the NZ dollar over-valued?

It all depends on one’s perspective. Relative to historical norms, the NZ dollar DOES seem over-valued. In real terms the currency has never been as high and the average level in nominal terms since NZ’s low inflation era began in 1992 is $US0.61.

But are these normal times? It’s not hard to conclude that economic conditions are fairly abnormal. Firstly, NZ’s terms of trade are at an elevated level, the highest since 1974. NZ’s terms of trade are largely driven by commodity prices, since commodities make up the bulk of NZ’s exports. Commodity prices are a key driver of the NZ dollar so it is not surprising that NZ has a very strong exchange rate in an environment of very strong commodity prices.

Secondly, we are in a post GFC world with significant debt concerns for the US, Continental Europe, UK and Japan. Interest rates in those countries are abnormally low and monetary policy settings, including quantitative easing, are far from normal. This has depressed those currencies relative to the value of the NZ dollar.

Such abnormal market conditions suggest that it is dangerous just to look at the value of the NZ dollar relative to history and make some sort of judgement on valuation.

We recently did some extensive modelling work on the NZ dollar and concluded that a taking backward-looking view is not a very profitable strategy. These models looked at mean reversion from historical averages and momentum type indicators. The value-add from using such models to take asset allocation tilts on various cross rates was inconsistent across periods and across different cross-rates.

A profitable strategy is likely to be one where a correct forecast is made about the future path of commodity prices, interest rate differentials between NZ and other countries, and relative growth prospects between NZ and the world. The problem is that these “inputs” are difficult to forecast and therein lies the difficulty in projecting future currency gyrations.

Looking a year ahead, we see scope for commodity prices to retreat after a strong run over the last decade. We also see more chance of upward pressure on NZ interest rates compared to current market pricing and we expect NZ’s economy to grow faster than others, following a period of underperformance. The first driver would be negative for the NZ dollar, but the latter two would be positive for the NZ dollar.

Whether the NZ dollar rises or falls will depend on which key driver for the NZ dollar predominates. There are, of course, many other factors which could influence the NZ dollar. Investor risk appetite, for example, is another key driver but one which is difficult to pin down.
Overall, we would put more weight on global factors dominating during the course of the next year. This could mean that the NZ dollar struggles to gain further traction, after the recent strong rally.

If we thought that the world was returning to more normal economic conditions, then a mean reversion model would call for a massive short position on the NZ dollar. Our central view is that these abnormal conditions are likely to linger for some time yet, which will probably mean that the NZ dollar continues to trade well in excess of historical norms. From current levels we see more downside risk than upside risk, but only have a mild short position on the NZ dollar given the wide bounds of uncertainty at the moment.