Comment: Fair warning issued

Comment:
Fair warning issued

This month, we take a look at some revealing research recently published by Johnathan Bayley, the senior currency strategist at Westpac. He has looked at the relationship between Eurobond activity and currency movements, and looked ahead at 'net issuance'.

The bottom line is that he is warning of a significant change from the current situation where Eurobond activity is helping keep the NZ$ high, inflation low, and therefore a lid on the OCR. His study points to a changed situation where Eurobond activity will be negative, helping drive down the currency at a time when some are forecasting a weakening for other more general reasons. In that coming situation, the NZ$ could well over-correct, causing significant inflation pressures and requiring the RBNZ to respond with a rising OCR.

Readers of our Comments will recognise the general scenario – this new study puts some more 'meat-on-the-bones' – and suggests the full impact may extend well into 2006 and 2007.

Eurobonds are NZ$ debt issues with NZ yields, sold to foreigners at the retail level. As such, they are not hedged, and the buyer takes the exchange risks.

Since 2001, such investors have experienced wonderful returns. Not only have they received high NZ yields which contrasts dramatically with what they are offered in their home currencies, they have seen these yields embellished with strong currency gains as well.

This combination has made Eurobond issues very easy to sell. And there have been huge amounts of them.

Regular readers of our News page have been able to track issuance monthly in the table in the left-hand column.

http://www.interest.co.nz/news.html

This tracks the two types of retail Eurobonds – the Uridashi, which are retail bonds bought by the Japanese (often thought of as a market dominated by the 'Japanese housewife', although of course it is much wider than that), and the Eurokiwi, which are retail bonds sold to retail investors in Europe and North America (often characterised as being pitched to 'Belgian dentists').

In 2004, almost $11 billion of these products were issued – about $7 billion into Uridashi, $4 billion into Eurokiwi.

All of this is in NZ$, and therefore runs through the NZ$ currency markets. Yen or Euro buys NZ$, increasing the demand for NZ$.

To put this into perspective, NZ exports were $31 billion in 2004, imports were $35 billion, and we paid for another $4 billion in net services. All these transactions ran through the currency markets as well, mostly offsetting each other but leaving a current account deficit of $8 billion. 2005 is expected to be worse.

However, significant positive capital flows created more demand for the currency than supply, and it rose significantly. Although these Eurobond transactions are not part of these capital flows, they have an important influence of the overall supply/demand for the currency and its market value.

As an aside, wholesale or large corporate funding activity in the NZ$ bond markets is probably not very influential, because these sophisticated players hedge their positions, which neutralises the currency impact.

Here's the rub: If you can track Eurobond issuance, you can forecast when they are going to be redeemed – all such bonds have a term. Bayley and Westpac have done this, and it makes sobering reading.

Separate to Bayley's observations, there is a view, although not the consensus view, that the NZ$'s long positive run is coming to an end, principally because the current account deficit is large, growing, and seems headed for +6% of GDP. This is the territory where foreign investors can see that the currency is about to turn, and the golden period of high-yield-plus-fx-gains will become high-yield-less-fx-losses, which cancels out any benefit to holding NZ$ yield products.

If you see this coming, the best thing is to get out early. Fx losses are calculated on your principal, and can quickly overwhelm a 6% yield, leaving you with a very poor hand indeed.

There may well be some Belgian dentists out there who recall that pain in the late 1990s. Being late to react can be very painful.

Balyey's data is clear. From mid 2005 and into 2006 and 2007, redemptions will exceed expected issues ("net issuance") at the thick end of $500 million per month - and all this at a time when the trading fundamentals are turning against the NZ$ currency.

As Bayley says, "we would argue that Eurobond activity is set to shift from being a driver of NZD strength to a driver of NZD weakness."

He also shows a persuasive link between Eurobond issuance and the currency rate itself, confirming the important influence such transactions have on the NZ$.

This research is valuable to investors in two ways. Firstly, it helps by firming up when these influences are expected to kick in where you and I will notice them. The first half of 2006 looks like when this trend will become important, with it lasting well into 2007. It also gives an indication of how severe the correction will be. While a series of half a billion dollars per month redemptions will be significant, there are some months that this level exceeds $1 billion per month.

Remember, the Japanese housewife and the Belgian dentist can't bring these redemptions forward. They are in for the ride, and will have to take the exchange rate on the date their bond matures. Their decision is important to the extent that they can roll over their investment into another bond. But, if they are facing losses, this is much less likely. So the redemption rate schedule is a treadmill the NZ$ cannot get off.

But it can be brought forward by others in the market. If they see it coming, demand for the NZ$ will wither, causing an earlier fall. Short sellers will see an opportunity too good to miss.

Typical of real-world markets, the reaction could easily overshoot. The RBNZ's recently won powers (March 2004) to intervene in the currency markets may be pressed into service following political pressure, ironically for exactly the reverse political reasons they were installed!

A sinking NZ$ will make imports suddenly much more expensive, and be inflationary. Farmers will smile, provided their distribution channel is not hedged too far out at high rates. The RBNZ will react when inflation exceeds 3%pa. The cost of money could rise significantly – the end of the era of so-called "cheap money" could be within the planable future.

If you are a borrower, consider locking in today's rates for a number of years.

If you are a depositor, note that rates will be higher in the future, and you should carefully assess business risks of the company you invest in. How will they fare if the economy turns down? Use our SQP Score© to make a short list, but research that list for future business risk. Professional advice will always pay for itself.

Some investors may also look to switch their exposure to investments outside this region – and that can include New Zealand companies with those attributes.
The above is just opinion, of course. You are encouraged to review the facts and form your own conclusions.

David Chaston
Publisher
www.interest.co.nz

Note for editors:

David Chaston is a commentator on New Zealand interest rates, and watches them through his on-line service www.interest.co.nz

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