Dairy production in New Zealand is falling, and that could push the Kiwi dollar towards parity against the Australian dollar, according to Joseph Capurso, senior currency strategist at the Commonwealth Bank
He suggests that a shrinking dairy herd in New Zealand, coupled with expected seasonal weakness in iron ore prices, looks set to “bear down on AUD/NZD”.
Yes, dairy cows could end up being the most influential driver of the currency pair, moving forward.
“Milk is New Zealand’s largest export. Iron ore is Australia’s largest commodity export. They are important influences on New Zealand’s and Australia’s terms of trade,” notes Capurso.
“So perhaps it should not come as a surprise that the spread in the terms of trade between Australia and New Zealand has become a more reliable driver of AUD/NZD.”
Terms of trade tracks the value of the exports of a particular country relative to the value of its imports.
The relationship between the AUD/NZD and the differential in the two nation’s terms of trade is shown in the chart below from the CBA.
According to Capurso, the terms of trade of spread suggests the AUD/NZD is near fair value right now, putting it at odds with interest rate differentials and the spread between Australian and New Zealand unemployment rates — past drivers of the currency pair — which suggest the rate should be near 1.15 rather than its present level of 104.25.
And, based on the outlook for milk and iron ore prices in the period ahead, Capurso suggests the AUD/NZD may be about to get a whole lot lower.
We are bullish about the milk price because we expect global milk supply to continue shrinking. While New Zealand is not the largest dairy producer, it is the world’s largest dairy exporter. Therefore, changes in New Zealand’s dairy production can have a large impact on the global dairy price and New Zealand’s terms of trade.
We estimate New Zealand’s dairy herd will shrink by an unprecedented 5% on top of last season’s 3% fall. This heavy slaughtering is irreversible and we expect this to translate into a 5% fall in New Zealand milk production this season. Similarly, we consider that the production slowdown in the European Union is more advanced than most other analysts are factoring in.
The chart below from the CBA tracks the size of New Zealand’s dairy herd versus actual dairy production. The size of the herd, hence production, is forecast to fall, placing upside pressure on dairy prices.
And, at the other end of the spectrum, the CBA believes that the outlook for iron ore prices — Australia’s largest goods export by dollar value — is lower, mirroring the sentiment expressed by an increasing number of analysts.
In contrast, our hard commodity analyst predicts the iron ore price will decrease from the current price just above $60 per ton to $40-45 per ton by the end of 2016. While Chinese steel production is currently high, Chinese steel production usually falls from September onwards because of a seasonal lull in construction during the northern winter months.
As a consequence of the two, Capurso suggests that “the terms of trade spread between Australia and New Zealand will continue to decrease”, placing further downside pressure on AUD/NZD in his opinion.
Being less than 5% away, that suggests a move to parity between the Australian and New Zealand dollars could well be on the cards.