Whilst the financial markets are still giving the probability of a NZ sovereign debt credit rating downgrade from AAA a 50%/50% chance, the likelihood of a downgrade has diminished in my view. The bottom-line is that Standard & Poor’s are not really in a position to question The Treasury’s GDP growth forecasts over coming years that deliver the tax revenue into the Government. S & P will assess the risk of these GDP growth forecasts not being met; however they would have to see actual budget deficits significantly larger than forecast deficits to downgrade the credit rating on an impaired ability to service and repay the debt. What might be more concerning for investors and borrowers in New Zealand is the prospect of S & P downgrading the credit ratings of the Australasian banks. S & P issued a press statement about their own changes of criteria and methodology for rating the Aussie banks several months ago, but nothing has been announced since. Any credit rating downgrades for the banks would flow though into a higher cost of longer-term funds and thus be passed through to corporate borrowing customers of the banks. These developments do suggest that any corporate borrower contemplating a RFP process to refinance or raise new bank debt would be well advised to do this sooner rather than later.

 

There continues to be a shortage of new corporate bond issues to meet the current investor demand. The banks are very flush with reinsurance cash that has come into NZ that will not be paid out on insurance claims for several months. Commercial paper issuance margins have been pushed down due to this weight of funds trying to find a home. There are rumours that HSBC bank are about to announce their first NZ retail bond issue to tap into this investor demand. The Genesis Energy 30-year subordinated Capital Bonds are apparently filling up well as small investors are attracted to the 8.50% yield without necessarily understanding the liquidity and credit risks of the security. 

The “End of the Golden Weather” is a classic Kiwi beach story and as we move into the month of May after an extended Indian summer in Auckland, it feels that the weather is turning and that the golden run for commodity markets (and thus the Kiwi dollar) may be coming to the end of their extended season. The extreme short-term volatility up and down in global commodity prices over recent weeks signals to me that the strong uptrend is nearing its end as the market participants cannot decide whether to buy or sell to get on the next trend. Such wild daily swings are often a signal that a major trend is coming to an end. What we may also be seeing is higher volumes of price hedging by the producers of commodities as they lock into the massive price gains, thus corporate profitability.

 

An article on the commodity markets in last week’s Economist magazine highlighted the imbalances and bubbles that have arise from the US exporting their loose monetary policy, super low interest rates and weak currency to emerging market economies who tie their currencies to the USD currency. These financial conditions have added to the boom in commodity prices and caused the resultant food price inflation worries for central banks around the world and similar worries for Middle-Eastern dictators, as it was food price increases that originally sparked the pro-democracy movements. The Economist cynically (and correctly) proffered that it was no coincidence that Swiss commodity trading house Glencore launched their IPO at the top of the commodity curve and with a frothy share price to boot! Their timing to sell their own shares to unsuspecting punters and cash-out at the top of the commodity cycle tells you something about risk/reward on these markets from here.

 

As has been stated in this column repeatedly for the last six months is that the tightening of monetary policy in China must be a negative for commodity prices, as the pace of Chinese demand and economic growth is slowed just a fraction. To date we have not really seen the tightening of credit and higher interest rates in China dent the commodity price increases. However, the change in monetary conditions may finally be starting to have an impact as recent Chinese economic data has not printed as strong as prior forecasts. There is no question that Chinese demand from the massive industrialisation, infrastructure build and urbanisation has caused a fundamental and paradigm shift upwards in commodity prices in recent years.  However, that structural increase in prices does not remove the cyclicality of commodity markets. The current higher prices will attract producer hedging (selling) and increased production which increases supply to meet the demand.

 

The long-term trend is still upwards for commodities (which is very good news for the NZ economy), however a significant short/medium term correction back in prices now looks much more likely. The implications for the NZD/USD exchange rate are therefore back towards 0.7000 over coming months, but firmly back up on rising NZ interest rates and commodity markets getting back on their uptrend in 2012.

 

The NZD/USD exchange rate has not depreciated as much as commodity prices over recent weeks. It appears overdue, in the short-term to catch up to the commodity price declines.

 

Going back a few weeks we had the US dollar being smashed in the FX markets for continuing loose monetary policy and the fiscal policy/debt ceiling of the US Government running into political roadblocks. The USD is now recovering in the markets due to a correction in commodity prices and the European sovereign debt situation deteriorating further. Super loose monetary policy and a weak fiscal position is precisely what we have in New Zealand right now, so why is the NZD not being slammed down? The answer of course is that growth/commodity/Asian-linked (AUD and NZD) currencies have been the darling of global investment markets and Government bond yields above 5.00% outweighs economic policy concerns for foreign investors.

 

The local currency markets are arguably still at a 50/50 probability on a NZ sovereign credit rating downgrade post this week’s budget. As more detail on the budget is filtered out beforehand, I am growing more comfortable that Standard & Poor’s will not downgrade NZ. The forecast fiscal deficits and return to budget surplus by 2015/2016 are heavily dependent upon GDP growth meeting The Treasury GDP growth forecasts. My view is that 2% GDP growth this year and 4% GDP growth next year are credible forecasts given the boost to the NZ economy that comes from the super high agriculture export commodity prices. The balance comes from whether households spend or save. Improving dairy farmer balance sheets from rising land values and income increases elsewhere auger well for the recent uptick in consumer spending (post earthquake) to continue for the rest of this year and into next. Government expenditure savings also come from the debt interest cost on Government bonds being closer to 5.00% than the 6.00% The Treasury would have been forecasting earlier. The budget will be lots of small tinkering adjustments that overall add up to enough Government expenditure control that satisfies Standard & Poors.

 

The NZD/USD exchange rate may therefore not suffer a two or three cent sell-off on a credit rating downgrade, however it still has some catching up to do on the weaker Euro against the USD – which has moved sharply below its support line at $1.4450 (now trading at $1.4060)