A Pullback-Induced Opportunity In NZD/JPY: A Divergence From Fundamental Drivers

by: Harvard Macro Team


Japan's sales tax increase amid a prolonged trend of disinflation and sluggish economic growth will pose additional, unanticipated risks to the Japanese economy that will elicit additional monetary easing.

New Zealand initial interest rate increases from 2.5% to 3% are just the beginning of a longer trend in higher interest rates.

The turmoil in Ukraine and the South China Sea in the past few weeks has moved the NZD/JPY away from its fundamental drivers.

ETFs such as AUNZ, FXY, and FXY allow investors new opportunities to get exposure to currency markets.

The Search For Yield

In an era where benchmark lending rates have flirted with the practical 0% lower bound, yield is hard to come by. The United States, Japan, and the United Kingdom have taken one step beyond simple zero-interest rate policies, embarking upon massive bond buying programs with which to push down interest rates at the long end of the yield curve. Keeping this in mind, I would like to detail the reward/risk prospects of a conventional carry trade that I believe presents a good short- and long-term trading opportunity. Furthermore, I offer the mechanics of the trade, detailing entry point, price target, stop, and the plan for exit.

New Zealand and Japan: The Landscape

In the past few months, New Zealand has reported robust economic growth. In the quarter ending December 2013, GDP grew 3.1% YoY and 0.9% QoQ. More importantly, the Governor of the Reserve Bank of New Zealand (RBNZ) Graeme Wheeler upped his forecast for GDP growth in the year ending March 2014 by 0.2% to 3.5%.

As for international trade, New Zealand is one of the few developed countries in the world today running trade surpluses. For February, exports increased almost 14% from $4.08B to $4.65B. Imports fell 0.8% from $3.77B to $3.74B. The February trade balance increased from $306M to $818M. For March, exports increased 9% to $5.08B and imports increased 11% to $4.16B. The March trade balance increased to $920M.

These numbers tell a remarkably bullish story for the kiwi dollar (NYSEARCA:AUNZ). Wheeler cites these strong figures as being drive by strong export commodity prices (dairy, food, and agriculture) and overall economic activity. However, Wheeler has expressed concern over inflationary pressures driven by the domestic market. But with the 0.2% drop in Q4 YoY inflation to 1.5%, some of his concerns seem to have been mitigated.

With regard to the New Zealand dollar, Wheeler has expressed that the currency is at a level that is too high to sustain in the long run. While these remarks are individually vague, they signify that the RBNZ governor is on the whole comfortable with the state of New Zealand's economy -- a decidedly hawkish lean.

As for Japan, the country has been fighting deflation for who knows how long. This is a story not worth discussing as it is so well engrained into mainstream news and there are more interesting issues to address. But as a quick summary, the Japanese economy can be pictured as follows: It is hampered by deflationary pressures, it is a historically export-based economy that has been running trade deficits because of increasing fuel costs and an aversion to nuclear power, it has a debt/GDP ratio of over 2, it is fighting a rapidly aging population, and it has had a modestly strengthening yen (NYSEARCA:FXY) that poses a bigger threat to future export competitiveness.

On April 1, 2014, Japan experienced a sales tax hike from 5% to 8%. As consumers pre-empted the rise, March retail sales climbed 11% YoY. Although it may not be entirely useful because of the anomalies in data that will be undoubtedly created by the sales tax hike, Japanese annualized GDP increased a slower-than-expected 0.7% in the quarter ending December 2013.

Price Drivers

Wheeler is generally perceived as Hawkish -- concerned primarily with inflation particularly in the upbeat housing market. Thus, as long as nothing major happens to contract the economy, it seems reasonable to assume that the RBNZ's desire to curb prices will precede concerns over currency strength and export competitiveness. This view is consistent with how Wheeler has in the past month made no mention of the strength of the currency (whereas he has in previous months) and made no attempt to talk down the currency.

Accordingly, the RBNZ has been tightening of late. On March 13, 2014, the RBNZ raised the official cash rate from 2.5% (where it has sat for more than two years) to 2.75%. In line with expectations, the RBNZ then increased interest rates once more to 3% on April 24, 2013. There is material significance in these moves, as these interest rate hikes make New Zealand the only country with liquid and freely traded financial markets to raise interest rates in over two years. Coincidentally, New Zealand was one of the countries (perhaps even the only) that increased interest rates in 2011, thereby setting itself up to break its own record. Thus, the overall feeling behind New Zealand's interest rate policy is that the RBNZ is on a tightening course. With the continued increase in the March trade surplus figures, I don't see any change in the course of monetary policy on the horizon.

In Japan, the situation is a bit more political. Prime Minister Shinzo Abe inherited the aforementioned sales tax increase from the previous Democratic Party government under Yoshikiko Noda, who set out the deal in 2012. The previous sales tax rise occurred in 1997 when the tax rate was taken from 3% to 5%; after this hike, the economy went into a recession for 1.5 years (April 1997 through October 1998). However, at the time, there were other factors involved such as the Asian currency crisis. With respect to how the economy reacted prior to the sales tax, the situation today and the situation then both had what seemed to be promising recoveries matriculating.

In the quarter ending June 1996, Japan saw 4.3% YoY GDP growth in the slow, post-housing bubble period. Today, we are seeing similarly inflated March data that would seem to verify the past trend. Obviously, the big question is whether or not this sales tax rise will precipitate another recession. I think it is unlikely given that the world is recovering and not declining. Nevertheless, it was for this reason (and the overall slack in the economy) that PM Abe appointed Haruhiko Kuroda as the Governor of the Bank of Japan (BOJ) in March 2013.

Until recently, Kuroda has done swimmingly to follow Abe's wishes, keeping the benchmark interest rate at 0% and buying 60-70T yen worth of Japanese government bonds. However, here is where the relationship gets a little tenuous. Abe opposed the sales tax hike and hoped to get around it by having Kuroda increase the amount of monetary easing by the BOJ. Unfortunately for Abe, Kuroda came out and said that his central mandate is to control prices; if and when Japan hits 2% inflation, Kuroda intends to hold back on monetary expansion -- refusing to add more easing simply to help the government borrow at lower rates. Although we don't know what holding back on easing means (tightening or just reducing the quantity of quantitative easing), Kuroda's intent to defy Abe is clear and Japanese markets will undoubtedly react poorly if this relationship gets worse.

As of now, the main point of ambiguity is that Kuroda has not specified whether the 2% inflation rate target applies to before or after the sales tax hike, which will raise prices. If Kuroda moves as the U.S. Fed moves, it will almost certainly be before the sales tax hike (thus adjusting the target upward). However, I interpret Kuroda's comments against Abe's wishes as showing Kuroda's Keynesian leanings, signaling that he wants to move away from monetary policy as the means to pull Japan out of its economic slump. Certainly, this is not too far fetched as Japan has been conducting vast bond purchases since 2001 without any phenomenal effects on economic growth or inflation.

The Consensus Trade (Long Term)

As supported by the chart below, the long NZD short JPY carry trade has made good money since December 2012. Given the interest rate differential between the "Antipodes" and the yen, it is no surprise that this carry trade has done exceedingly well (New Zealand's benchmark rate is 3% above that of Japan). With very easy monetary policy, nonexistent inflation, and slow economic growth behind the yen, New Zealand's tight monetary policy, steady inflation, and robust economic growth makes the long NZD/JPY carry trade all the more appealing in the long term. This is even more relevant given the recent pullback discussed later.

Click to enlarge images.

Source: CQG.

Ultimately, I think we are in the interim period before another large depreciation of the yen and appreciation of the kiwi. This position can be made by buying both and YCS.

The Consensus Trade (Medium Term)

Regarding the JPY side of the NZD/JPY currency pair, the consensus is that retail sales and thus the economy may be hurt in April, but will recover in May. Again, this is because the economy is not in recession, and many believe it to be modestly robust. Furthermore, it seems worthwhile to note that there is another scheduled sales tax increase (also instituted by the Noda government) in October 2015 -- so I don't think that this recent sales tax hike was a be all, end all. However, that is not to say that the definite economic slack to come in the coming months won't put substantial political pressure on the government and the BOJ to act. People aren't eager to stomach short-term pain for long-term gain.

As for the NZD side, there is a general consensus that interest rates will continue to increase. With the March rate decision, the RBNZ said that it expects to increase interest rates another 2% by 2016. Therefore, we have a compelling trading opportunity in which both the medium and long-term outlooks are fundamentally aligned. I would suggest being long and long.

Plan of Entry

We can use the 2.7% pullback from 89.95 to initiate a new long position in NZD/JPY (see chart below). Thus, with the fundamental thesis in mind, we are looking to enter the trade at a rate that makes sense technically.

Source: CQG.

Ultimately, I want to be long NZD/JPY at the 50-day SMA, formulated by buying WisdomTree Dreyfus New Zealand Dollar Fund ETF and ProShares UltraShort Yen in equal notional amounts. Both of these ETFs trade with decent liquidity.

Underneath the current market rate, there is a slew of support levels, including the 38.2% retracement from the early March/early April move, the low from mid-March, and the 50-day moving average itself (which has held these past few days and proved to be similarly formidable as a structural level throughout February). This leads me to believe that there will be at least a stall if not a rebound at the current levels.

On a psychological level, I think the current retracement is not the start of a broader trend reversion. While the move from early February to early April covered 850 pips in two months, the current retracement has covered 264 pips in one month -- almost two times on the way down than the way up. Keeping in mind economic principle that risk should happen faster than reward, it seems that the market is simply taking a breather in front of the FOMC rate decision and the NFP later this week. On the whole, this setup is bullish.

I think this trade has under involvement because of the following:

The risk-off mentality generated by the issues of Russia in Ukraine has generated what I see to be a correction from the big move starting in February (as JPY is a haven currency). This correction has flown in the face of fundamentals, as the April increase in New Zealand's interest rates to 3% saw an initial rise in the kiwi, but ultimately geopolitical turmoil pushed it back down. I'm not necessarily willing to say that this geopolitical turmoil is temporary, but I think these events have pushed up the reward/risk ratio of the long NZD/JPY trade so that if tensions were to cool, this position would make good money.

China's slowing economic growth has been on overhang on New Zealand, as China is its largest trade partner. However, given that exports and imports have been robust and that the geopolitical turmoil in Eastern Europe has been putting upward pressures on agricultural commodities (that helps New Zealand's exports), I don't see this risk manifesting.

New Zealand's Q4 smaller-than-expected CPI figures put some doubts about whether or not Wheeler will still decide to raise interest rates and therefore suppressed the kiwi.

I think the following will happen:

New Zealand will continue to increase its interest rates (2% by 2016) to curb its housing prices (the most recent REINZ figures showed a 3.4% increase in housing prices in March 2014). I see that Wheeler will continue to be averse to housing inflation, as no central banker wants to be the one who fueled a housing bubble after the GFC in 2008. The graph below shows index over the past year.

The BOJ, regardless of how adamant Kuroda is with regard to reining in monetary purchases after inflation hits their 2% target, will need to add some sort of monetary stimulus because retail sales and the economy will be slow in the coming months. Noting how a few months' worth of retail spending was piled into March, I think this is a reasonable assumption to make.

The world will continue to fear inflation and the prospect of inflation with so much cheap money having flooded the markets in the years following 2008. This will support Wheeler's moves to continue to increase interest rates.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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