AUDNZD Revisited - Inflation and A Berning Socialist Experiment

First of all, sorry for this slightly outdated post, but I wanted to go through with it as it is something I've been trying to get off my plate for a while...

Good old AUDNZD...it seems like forever since this pair has been floating around the cellar of its historical range.

I've written about this pair in the past here (we could've caught some small moves in the past, I am still swimming in this ocean looking for the big fish of a return) - the large range that it trades between is largely reflective of the business cycle between the two countries and the close tie between the two economies (although that link is largely a one-way street where New Zealand depends on Australia)

As the market slowly starts mulling over the possibility of rising inflation - I had the crazy idea that going long the pair can be a viable and innovative way to express that exposure.

First thing's first: why would it reflect an exposure of rising inflation?

Like we've detailed in the past, the pair trades closely in line with the relative terms of trade between the two countries.




So let's extrapolate that - if you have a bull market in commodities what would happen?

Well, back in 2005 - 2011 when we had a bull market in almost all commodities, AUDNZD traded up to historical highs of the range - yes, agricultural products were in a bull market as well.

If we were to have a repeat of this type of inflationary pressures (the bull market for energy, metals, and grains), I would speculate a similar response for the commodities index as well as AUDNZD.

In addition, there are a couple of recent developments that I find interesting here:

The fundamental trends between the two countries' economies continue to trend favorably of a higher AUDNZD (from historically bad levels). Furthermore, divergence in Central Bank action as well as some very interesting political developments in New Zealand and the RBNZ that can potentially be very impactful.


Looking at this further:

1)  Let's look at some other fundamental factors:

The economy through the lens of unemployment has been in favor of New Zealand over Australia for the better part of almost 4 years. It seems to have stabilized - with the way the global economy has started to grow, I would think the "worst" has been priced in.




Looking at the rates market with inflation accounted for we have started to see a bottom and a divergence between the two countries if we don't get a horrific outlier of a miss.



*Real rates calculated via extrapolated CPI.

**Using AU CPI print projected at 0.8% from Westpac

I assume a continued divergence would lead to eventual central bank action:

2) The Bernie Sanders experiment is officially underway in New Zealand.

The newly elected prime minister of New Zealand, Jacinda Ardern is described as the following:

-Political allies NZ First (a socially conservative party with a hint of xenophobia) and the Greens (your stereotypical green party)

-Wants jobless rate to fall to 4% from 4.8%, in turn probably support reform the RBNZ (Link) to focus on not only inflation but also full employment

-Doesn't like immigration, blames it for rising housing costs

-Wants to restrict trade

To me, she does not remind me of Macron or Trump as some media outlets have stated. To me, she's much closer to Bernie or Elizabeth Warren, especially when it comes to the economic policies.

New Zealanders, are you ready to feel the Bern?

Since Ardern is set on forcing the rate of unemployment lower, and the finance minister has explicitly stated the intention to have the RBNZ change its focus to include full employment, it is probably to assume that their next Governor appointment will focus on pushing through said agenda.

The full employment and low and steady inflation dual mandate are comparable to that of the US Fed - the two mandates contradict each other: if there is true full employment, inflation would be ripping; if there is low and steady inflation, chances are you are unlikely at true full employment.

The two dynamics demand some favoritism towards one. I would assume the favor would be towards unemployment with Ardern. 

What does that mean? Well looking at WIRP at the end of the year in 2017 (apologies for the outdated data), it seems that the market is suspecting that there will is a 75% chance for a hike in 2018 despite the RBNZ explicitly stating that they will keep rates lower for the next two years! Depending what the market prices throughout the year, there could be good risk-reward for a fade.

I would deem the risk of a hike as overpriced.

In addition, revisiting the fundamentals above, it wouldn't surprise me if they actually lowered rates before they raise them. From a historical perspective, it wouldn't be out of the question.

On the other hand, Australia WIRP at the end of last year was pricing in the similar odds for a hike as New Zealand. The differences here is where I think presents the opportunity. Ultimately, this economy is one that is trending upwards from lows and can get a push from rising metals and energy prices - especially if you buy into the concept of higher inflationary pressures.

Contrarily, I would deem the risk of a hike underpriced here.

Conclusion:

I believe AUDNZD looks like a good way to short NZD and express a long overall inflation view. To purely play the developments in New Zealand, trading the short end rates curve in NZD is also another way to potentially play it. However, if I recall correctly, NZD rates were relatively illiquid. To purely play the inflation view, one can always simply go long AUD by itself, but you expose yourself to USD risk. In my opinion, the fact that the pair is near the bottom of the range introduces convexity to the trade.

What can go wrong:

AUDNZD obviously has both the Aussie and Kiwi components - I believe if inflation rises, one can potentially make money on the trade even without the NZD scenario of the RBNZ lowering rates materializing...However, if I am terribly wrong regarding the Australian economy and/or rising inflation, you can be at risk as well for your Kiwi view. Conversely, if I am terribly wrong about New Zealand, you can be at risk for your inflation view.

Decisions, decisions. A decision that I'll leave up to you.