The EUR/NZD currency pair, which expresses the value of the euro in terms of the New Zealand dollar, remains both above levels that were last seen at the start of 2020 (“pre-COVID-19”) and below the heights of March 2020 (the month in which equities were at their lows after crashing in Q1 2020).
The euro has strengthened significantly against the U.S. dollar this year, owing to significant monetary interventions that have seen USD rates collapse to the zero lower bound. Both EUR and NZD have benefited from lower oil prices too, since both the euro area and New Zealand are net importers of crude oil products.
It is prudent to always check whether a currency pair is correlated to risk assets. One of the best barometers of global risk appetite is the U.S. equity market, given its historical outperformance globally and the popularity as evidenced by international capital flows. (As indicated by U.S. Treasury data, foreigners made net purchases of U.S. equities every month except April, between January and July 2020; a total net inflow of almost $140 billion.)
The chart below illustrates the generally negative relationship between EUR/NZD (the black line) and S&P 500 futures prices (the red line).
(Source: TradingView. The same applies to price charts presented hereafter.)
Occasionally these instruments are aligned positively, but usually only for brief periods. The euro tends to strengthen against other currencies when it is also strengthening against the U.S. dollar. When USD is weakening, U.S. risk assets become more attractive in international FX terms, and thus a stronger euro is usually associated with risk-on activity.
There are, of course, exceptions to this – a stark example being earlier this year (March 2020), when EUR spiked as global equities sold off. This was a mechanical move owing to capital repatriation as short-EUR carry trades were unwound, while U.S. interest rate cuts sedimented the euro’s stronger position.
However, excluding these exceptional one-off adjustments, usually the euro will correlated positively with risk asset prices, and even gold prices (since commodities such as gold are principally denominated in U.S. dollars). This also applies to risk-on commodities like oil, although oil is known to have a life of its own, with its own unique sources of volatility (including geopolitics).
NZD is considered a risk-on currency owing to New Zealand’s smaller, less-sophisticated economy which often tries to support its export industries to support a stronger current account (and by extension, its domestic GDP growth and employment rate). Because of the smaller size of the NZD market, relative to other more liquid currencies such as USD, EUR and JPY, risk-on and risk-off moves usually create relatively stronger moves in NZD (i.e., the smaller the market by volume, the more market moves tend to find amplification).
Tourism is also important for New Zealand, more so than other countries. It is difficult to truly quantify the total (direct and indirect) dependence of a country’s GDP on inbound tourism (net of outbound tourism), but the COVID-19 pandemic has disproportionately affected New Zealand relative to most other countries around the world. This is to compare New Zealand to major European and American countries. Around 20% of jobs in New Zealand are thought to be built on the tourism industry.
If we look to terms of trade (the ratio between a country’s export and import prices), both German (a nation serving as a proxy for the euro area) and New Zealand terms of trade are higher on the year. In fact, New Zealand terms of trade appears to have benefited more so than German terms of trade. Yet, given the dependence that New Zealand has on the tourism industry, the real effects of the current crisis are probably yet to truly manifest in the macroeconomic indicators (including growth and unemployment).
(Source: Trading Economics)
A significant rebound globally could certainly support NZD over EUR in the sense that the market would likely “de-risk” NZD (reduce the risk premium associated with holding NZD). However, as it stands, it is likely that the global contraction in the tourism industry is going to create some lasting effects which will eventually feed into both the New Zealand unemployment rate and GDP, as well as the New Zealand current account.
Overseas visitor arrivals in New Zealand dropped by 243,289 or 96.9 percent year on year, to 7,842 in August of 2020 (see below).
(Source: Trading Economics)
Fiscal interventions will help to buffer this, but only so much. Ultimately, if travelers are fearful of contracting COVID-19 for at least another six months (or longer), it is going to be extremely difficult for New Zealand’s tourism industry to hold out without reducing employment dramatically. Government spending is one significant component of GDP, as is consumer spending and exports net of imports. However, due to issues surrounding fiscal sustainability, the government cannot plug the gap forever.
Therefore, in the short to medium term, we should be watchful of New Zealand macroeconomic data. The risks for NZD are quite high, while interest in the euro is apparently building. The euro has always been a reserve currency (second only to the U.S. dollar). Yet, with the U.S. target interest rate at only 0.00-0.25% at present, EUR has become a more fierce competitor to USD this year. More interest in the euro, coupled with NZD risks, could, in fact, lend to a higher EUR/NZD rate in the medium term (admittedly, this would contrast with an earlier view I have taken on this pair).
On a longer-term basis, a Purchasing Power Parity model, which I construct below using OECD model data, implies a fair value (as of 2019) of approximately 2.06. The fair value will likely be revealed as somewhat different in 2020 (when that data point is released in 2021), but not significantly so. We can assume 2020 fair value is still above 2.00. Using the 2.00 handle as a target would suggest that EUR/NZD is currently undervalued by almost 12% at present (from the current market price of 1.77).
We can also assess the current central bank rates of these two countries in relation to emerging inflation rates this year (on a year-over-year basis). The table below summarizes these rates to find the change in the central bank rate implied “real yield” for EUR and NZD. Note that euro area inflation is measured monthly, while New Zealand inflation is measured quarterly; more recent inflation data is available for the euro area which reveals deflation in August and September 2020, however, the June year-over-year rate of +30 basis points is used as a fairer comparable with Q2 2020 NZ inflation.
(Source: Trading Economics)
As illustrated in the table above, the real yield (implied by central bank rates and year-over-year inflation rates) has improved in favor of EUR/NZD strength. Hence, EUR/NZD is undervalued on a PPP basis and offers greater value today, in terms of its inflation-adjusted yield, than it did at the start of the year. All the while, we are approaching the winter months during a second global wave of COVID-19 which is likely to place further pressure on the global tourism industry, disproportionately affecting countries such as New Zealand.
While I previously formed a case for a potentially weaker EUR/NZD rate, it would appear that several factors are lining up to provide EUR/NZD with a path to a higher rate towards its PPP-implied fair value above the 2.00 handle. Since my last article, EUR/NZD has effectively consolidated (mostly unchanged). Over the short to medium term, I would be unsurprised to see NZD struggle against EUR.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.