Tuesday, September 22, 2009

Lessons Of The Recent New Zealand Dollar Rally

One currency that unlike the British pound and the Ukrainian hryvnia has continued a fairly predictive pattern is the New Zealand dollar. Between March 2008 and March 2009, it dropped nearly 40% against the USD, from 81 US Cents to 49 US Cents, with most of the drop coming after August when stock markets started to plunge. But since then it has staged a spectacular rally, reaching a new 2009 high of 72 US Cents (Up nearly 50% from the March low!). Part of that reflects the general weakness of the U.S. dollar, but it also reflects a particular strength of the NZD, as it has risen against the euro by nearly 20%.

There are two (or actually three) lessons of this: First of all, there's little or nothing in the fundamentals of New Zealand's economy that motivate these kinds of wild fluctuations, but because it disrupts business planning it has a disruptive effect on the New Zealand economy (and to a much lesser extent (as New Zealand means less to the rest of the world, than the rest of the world means to New Zealand), the rest of the world economy). The Friedmanite myth that fluctuating fiat exchange rates would somehow stabilize economies based on different fundamentals is thus once again proven to be a myth.

This again illustrates the point that I've pointed out here and here that the [uncovered] “interest parity condition" doesn't hold and that countries with high yields will give investors higher return. Even factoring in last year's big drop in the exchange rates of high interest rate countries, high interest rate countries offered much higher return over a longer period of time than low interest rate countries. The big rally this year for the high interest rate currencies of the Australian and New Zealand dollars makes the statistical superiority of high interest rate countries even greater.

The third point is that the future of the New Zealand dollar's exchange rate depends on how global stock markets will perform. It (and more importantly assets denominated in it) is so to speak a "high beta asset". If global stock markets rally further, then so will the New Zealand dollar. If global stock markets sell off, then so will the New Zealand dollar. Since I personally think that the risk is high of a stock market sell off; the risk is also high that the New Zealand dollar will sell off.


Blogger SAJ said...

I wrote a kandidatuppsats as it's called in swedish on this subject and the uncovered interest rate parity does hold. The exchange rate is simply too volatile for anyone to be able to exploit the differences in yield profitably.

The covered interest rate parity condition on the other hand doesn't hold.

8:23 AM  
Blogger stefankarlsson said...

Where can this "kandidatuppsats" be found? Because according to the data I've analyzed, the uncovered interest parity certainly doesn't hold. For example, the cumulative return in U.S. dollar terms was 264% in the United States, and 885% in New Zealand between 1984 and 2008. In Japan the yield was 371% and in Australia 488%. With the higher interest rates and dramatic NZD (and AUD) appreciation, that gap would be even larger if 2009 were included.

10:29 PM  
Blogger Phil said...

How can the NZ dollar be so valuable against countries that have considerable oil assets, a solid manufacturing base and a higher tax base, in particular the GBP vs the NZ dollar.
I mean all NZ has is a load of sheep and a rapidly declining tourist industry ( caused by the high NZ dollar ) also we are not hearing from the exporters, why are they not up in arms at the unrealistic NZ dollar.

1:31 AM  
Blogger CV said...


I have to side with Stefan here, the UIP is almost uniformly found not to hold in most empirical studies.

"The exchange rate is simply too volatile for anyone to be able to exploit the differences in yield profitably"

Right, this may be a fair point (subject to an empirical survey I would think), but it is one made "after the fact" I think with the fact being that exchange rates does not! move to correct yield differentials. Look at the carry trade as Stefan talks about in this post ... "disequilibrium" may exist long enough to profit from it and I find it very hard to believe that most standard state of the art FX algorithmic trading models do not include some form of "trading rule" based on the behaviour between risky assets and high yielding currencies.


1:01 PM  

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