The big short in currencies?

November 21, 2016 01:00 PM

Many of you may have seen the film “The Big Short” on the 2008 financial crisis, based on the book by the same name. The term also could describe the New Zealand/Canadaian dollar (NZD/CAD) currency pair. Here is why.

Both the kiwi (NZD) and loonie (CAD) are known as typical commodity currencies, with the former dependent upon dairy products and China’s appetite to import agriculture commodities, while the latter is known as the energy currency and dependent upon the U.S. energy demand. 

Canada’s ability to stave off the oil slump is seen through the recovery in non-energy jobs as well as the bounce in GDP to 1.3% year-over-year in July. As a result, the Bank of Canada made two 25-basis point rate cuts to its overnight lending rate in 2015 to reach a six-year low of 0.50%. The Reserve Bank of New Zealand cut rates four times from 3.50% in May 2015 to 2.0% in August 2016.

The RBNZ does not wish to remain stuck with the highest-yielding G10 currency in a near-zero yield world. RBNZ’s Assistant Governor John McDermott stated in early October the central banks’ “current projections and assumptions indicate that further policy easing will be required to ensure that future inflation settles near the middle of the target range.” McDermott added that Q3 inflation is expected to be low.

With a benchmark overnight rate of 2.0%, the RBNZ’s rate is the highest in the G10 world. This makes it highly vulnerable to falling equity markets as traders unwind carry trades away from high yielding currencies to lower yielders such as the euro and Japanese yen. Just look at the high correlation between NZD pairs and the Dow Jones, S&P 500 and DAX30. NZD/JPY has a 0.66 weekly correlation with the Dow between Jan. 1 and Oct. 17, the second highest pair after AUD/JPY. If indices extend their sell-off in Q4, NZD/CAD would be negatively affected. 

Bank of Canada Governor Stephen S. Poloz said in September that the weakness in Canada’s exports may be misleading because more companies have begun building facilities abroad, with sales by Canadian-owned foreign affiliates almost matching the amount of total exports sold from Canada, which implies there is almost as large a Canadian economy operating in foreign countries as there is in the domestic export sector.”

The loonie’s fundamentals may also be supported by stabilizing oil prices. U.S. crude oil held above the 
$39 per barrel support level before breaking above the 100-week moving average ($46.60) for the first time since August 2014. If this technical trend holds, then its implied target could be near $75. Whether this will happen remains a considerable challenge given OPEC’s uncertain agreement to cut production. As of mid-October, oil is among the top three performing commodities year-to-date, rising 35%. New Zealand dairy prices are up 22% year-to-date but are showing signs of exhaustion. 

The technical arguments to sell NZD/CAD include: A quadruple top occurring in a matter of two years failing to break 19-year high; Deteriorating monthly stochastics indicate downtrend; Weekly trendline support from April lows indicates preliminary 0.92 target; Trendline support from August 2015 lows  target 0.89; Pattern of two rising quarters followed by one falling quarter suggesting Q4 to end lower; and NZD/CAD has risen for a remarkable seven consecutive years into 2015 (see “Commodity currency top” below). It is already down in 2016. 

NZD/CAD faces preliminary support at the September 2015 trendline of 0.8910, which coincides with the 200-week moving average. Subsequent foundation stands at 0.8600. Any rebound above 0.9700 would derail the bear.0)

About the Author

Ashraf Laidi