The New Zealand Dollar and El Nino: Recession and Potential RBNZ Action

The New Zealand dollar faces downside pressures owing to a potentially drought-inspired recession.

The world is in its latest El Nino weather event, according to forecasters this could well be the strongest such event in more than 50 years. (Above: Ocean surface tempratures are unusually high in the tropics).

The impact on commodity-reliant currencies will be notable with the New Zealand dollar in particular likely to feel the heat.

The reason for the outsized impact on the NZD lies with the economy’s dependence on the dairy sector. Dairy exports to China are a mainstay of the economy and stresses to the sector are ultimately fed through into the NZ exchange rate complex.

"A 15% reduction in Australian wheat yields, a ferocious upcoming South Pacific cyclone season, and severe drought in Papua New Guinea, Vanuatu, and Ethiopia. We’re only getting started. Here in New Zealand, severe droughts are typically associated with recession, and the forecast is that areas such as the Wairarapa and parts of Canterbury are headed for trouble," says a currency briefing from ANZ Research.

Should the Reserve Bank of New Zealand feel that the economy is threatened by drought they could well execute another interest rate cut.

Falling interest rates undermine the NZ dollar, and we read the scenario as being NZD-negative.

However, ANZ note that the farming scene is very different from 1998 – irrigation is far more widespread. There has also been plenty of warning, and many farmers have reduced stock numbers early.

“But a lack of free water from the sky will still increase costs and reduce value-add and profits across the sector, even for those fortunate enough to have access to irrigation – and some will face limits on their water usage,” say ANZ Research.

An El Nino drought is already being priced into the New Zealand dollar with the expected hit to New Zealand production playing a large part of the story behind the recent bounce in global dairy prices off their extreme lows.

“It’s the wrong reason – it’s hardly good news on balance for New Zealand farmers – and it implies that any pleasant surprise regarding the severity of the weather event could be met by an unpleasant surprise on the price front,” say ANZ.

RBNZ to Cut Again Warn BNZ

Most analysts we are in contact with expect the Reserve Bank of New Zealand to cut rates once more.

BNZ say they expect the RBNZ to cut to a cyclical trough of 2.50% by year-end but are ambivalent as to whether the Bank moves at next week’s meeting or waits until Dec.  

“We therefore see the better risk-reward in receiving the Dec meeting, where only slightly more than a 50% chance of a 25bps cut is currently priced,” say BNZ, “On a cut, we anticipate the market may be inclined to price more, unless the accompanying RBNZ statement is very strident in saying no further cuts are likely.

Could we therefore be seeing the best levels in the NZ dollar at the present time?