The New Zealand dollar weakened slightly across the board earlier today following another weak auction of dairy products.
Today’s Global Dairy Trade (GDT) auction saw the index decline 3.1%. Expectations – or hopes – among New Zealand farmers had been for some stabilisation of prices after a 50% decline already this year. New Zealand is the largest exporter of whole milk powder and the price of that key component of the index fell 5% to 6% across all contract periods.
Dairy farmers will be disappointed with the weak price auction, but the buoyant New Zealand economy gives prime minister John Key plenty to celebrate. Photo: THinkstock
The online GDT auction, in which thousands of tonnes of products are bought and sold, occurs every two weeks. The GDT Index is determined by the prices obtained across a range of products, including whole milk powder, butter and cheese.
The chart below puts the decline in dairy prices over the last year in perspective. 
However, prices rises in other commodities New Zealand exports (such as meat and wool) remain solid, and are partially offsetting the fall in dairy prices. The chart below contrasts the performance of “hard” commodities important to Australia (iron ore, coal, metals) with New Zealand’s “soft” commodity exports (food products).
The decline in the index of hard commodities has been deeper and more prolonged, but for the Australia economy, the offsetting factor has been a huge increase in production over the past few years. This is now showing up in the export numbers, which are making a significant contribution to GDP growth. New Zealand’s output of dairy products has also increased, but not of the same magnitude, due to land and environmental constraints.
Nevertheless, both the Reserve Bank of New Zealand and its Australian counterpart are calling for further declines in their respective exchange rates to reflect falling commodity prices.
Positive outlook
But in the case of New Zealand, there are other factors at play that are putting upward pressure on the NZ dollar. Recent economic data suggests third quarter GDP growth will come in around 0.80% to 1.00% (readers from Europe and elsewhere should note that this is the quarterly number, not annual). So growth for calendar 2014 looks like being in the 3.5% to 4.00% range.
Further support for this positive outlook came from Monday’s September quarter retail sales number: the 1.5% increase in real terms was the biggest in two years. Apart from general optimism among consumers, the high exchange rate over recent years is lowering retail prices, enticing Kiwi shoppers to open their wallets. “Tradeables” inflation – goods and services open to international competition – is negative, and this has dragged the headline CPI inflation level down to 1%, which is the bottom of the RBNZ’s target range. 
Low inflation conundrum
The low inflation rate is a “conundrum” for the RBNZ, because its models suggest economic growth over the last couple of years has been above potential and the economy should, therefore, be experiencing rising inflationary pressures, not a softening.
Hence, after raising its policy rate by 100 basis points so far this year to 3.5%, the central bank has indicated monetary policy is on hold for a “period of assessment” while it gets its head around what’s going on. But that hasn't stopped hardline RBNZ Governor Graeme Wheeler reiterating last week the assessment that the neutral policy rate, and therefore target, is about 4.5%.
In reaction to the various indicators over the last couple of weeks, the bellwether two-year swap rate has risen by around 10 basis points to be resting just below 4% today. That increase might not sound much, but in a search-for-yield global environment it has an impact, as shown in the chart below that tracks the NZDUSD against the spread between the US and NZ two-year swap rates.
US and NZ two-year swap rates spread
The NZDUSD has been under pressure since peaking at 88.40 in July, and has since come down about 10%. But the Trade-Weighted-index, the measure the RBNZ watches, is off only half that amount (as seen in the following chart), largely due to the offsetting effects of a stronger NZDJPY and NZDAUD. 
While dairy prices are still a risk for the NZ dollar, overall commodity prices are holding up reasonably well. Meanwhile, strong economic growth and positive interest rate differentials are providing support for the Kiwi. My latest technical analysis of the NZDUSD is illustrated below.
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