FYI | Nov 27 2008
By Andrew Nelson
Over the last four months we have witnessed a correction of historical proportions in the currencies of Australia and New Zealand. The AUD has fallen 27% and the NZD 19% on a trade-weighted basis since mid-July. This is the largest depreciation ever to be recorded in either currency over such a short period of time.
There was a brief respite for both currencies in September after the first big sell-down, but the beginning of October saw the selling resume. The fortunes of both currencies were tracking the deterioration of international financial markets and the Aussie lost close to 20% on a trade-weighted basis in less than 10 trading days.
There was a brief bounce later in October as market sentiment improved, but the fortunes of both currencies have been flagging since then. Equity markets have plummeted, commodity prices have fallen further, credit markets have seen renewed tension and the Aussie and Kiwi have followed the markets lower.
The interesting dynamic in this decline is the absence of interest rate talk, which has traditionally been a major driver for both currencies.
In fact, the start of the downturn for each began back in late July early August when the prospect of a rate cut was looking more and more likely. But it’s hard to tell how much the beginning of the downturn had to do with the interest rate outlook and how much it had to do with the economic outlook.
That was the time when global economic conditions began to weaken appreciably, when the bottom started falling out of equity markets and which was heralded in Australia by a massive turn for the worse in commodity markets.
That was when the you know what hit the fan, uncertainty exploded and risk sentiment evaporated. Carry positions were unwound from historically large positions, which led to an unprecedented carry drawdown with losses in both the AUD and NZD far exceeding any prior carry corrections.
One thing that is certain is that the Kiwi started falling first. But then the NZ economy has been in obvious trouble for several more months than the Australian economy.
Economists at Danske Bank think that while the cyclical turn in monetary policy was certainly a nail in the coffin for both currencies, the importance of relative interest rates has faded in recent months. So if relative interest rates are just a nail in the coffin, then the fall in world equity and commodity markets, which has acted as a proxy for risk sentiment and the global business cycle, is the coffin itself.
The economists note that once the AUD and NZD started to fall, correlations with commodity prices and equities have risen. This demonstrates a de-coupling of both currencies from interests rate differentials and their re-coupling to the global business cycle as well as overall risk appetite in the financial market.
Danske agrees that the bursting of the commodity price bubble explains a great deal of the weakening of both AUD and NZD. We all know that the Aussie is one of the worlds favourite “commodity currencies”. But it is the intensification of the financial crisis and the extreme volatility that has accompanied it that is an even more important driver of the Aussie and Kiwi’s demise.
Look back a few months and years (in the period 2002-07) and the commodity bubble was still bubbling, the interest differential was still very attractive and both the Aussie and Kiwi were very overvalued due to a historically large build-up in carry positions. At the same time the USD was undervalued, so the gap between was large, too large.
It may still be too large.
The economists from Danske think it would be reasonable to believe the large correction in AUD and NZD implies that both currencies have returned to fair value after having been significantly overvalued. If so, then both are where they should be and no near-term recovery is in sight. There aren’t many things trading above fair value right now.
The bank expects weak commodity markets will continue to weigh on both AUD and NZD in the short term and if the current environment of a global recession and financial distress continues, the accompanying pressure could send both the Aussie and Kiwi even lower. Danske sees neither currency as being meaningfully undervalued.
The only good news for the Aussie to come from Danske’s assessment is that no matter how bad it gets, it will be even worse for the Kiwi.
