Your Quarterly E-Zine
Edition 11 • December 2019

This website contains the latest edition of Forsyth Barr Focus, a quarterly on-line magazine written by senior members of Forsyth Barr's investment team.

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A currency affair

Who knows where the New Zealand dollar is heading? The only thing we can say with absolute certainty about currency forecasting is “show me a commentator who alleges to know precisely where the New Zealand dollar is going, and we’ll show you a liar.”

Not even the Reserve Bank of New Zealand, with its surfeit of intellectual prowess, its international connections and a legacy of leading Central Bank thinking and actions internationally - think ‘independence’, ‘inflation targeting’ and ‘macro-prudential tools’ - attempts to estimate the future worth of our currency.

Sure, they detail forward-looking levels for the New Zealand dollar, but these are a series of technical outputs from their monetary policy modelling and not an outright set of stand-alone currency forecasts.

Our Reserve Bank must know a thing or two about preserving their reputation when it comes to currency forecasting. It’s not the same for private sector commentators who seem more willing to trash their reputations continually.

Graph 1 below displays the accuracy of currency forecasts when predicting the value of the New Zealand dollar in 12 months’ time.

Graph 1: Consensus NZD/USD forecasts 12 months forward versus actual NZD/USD lagged 12 month.

Forecasters appear to have correctly captured the longer-term trends, the broader appreciation and depreciation of the Kiwi, however, there are acute periods of deviation between predictions and the actual rate of the New Zealand dollar.

As manager of the Summer KiwiSaver Scheme, we’ve decided to actively manage the foreign currency exposures associated with our international shares - that is we make a call as to when and by how much we will hedge any foreign currency exposure.

Another option, which by our analysis appears to be the industry standard, is to hedge a fixed portion of any foreign currency exposure – a sort of “set-and-forget.”

While it may be easier to identify the longer-term, multi-year trends, we also need to consider managing currency risk over the shorter-term.

As part of our active currency management strategy, we believe we can add value to our investors’ Summer KiwiSaver Scheme investments that have foreign currency exposure by dynamically increasing or reducing hedging levels over the shorter-term.

One of our quantitative tools uses regression analysis, where we take the value of selected known variables, in order to solve for the value of an unknown variable, in this case the New Zealand dollar.

Our inputs are the sort of things that impact on the expected performance of the New Zealand economy and New Zealand financial asset prices, in general.

Here, our known or input variables are the value of our commodity export receipts, the relationship between New Zealand and international monetary policy and an assessment of global investment risk – very simply “risk on ” or “risk off”, or somewhere in between.

We currently calculate the fair value of the Kiwi at around 0.6640, which compares to an actual of value of close to 0.6425. It’s tempting to hedge given the variation in our fair value calculation and actual rate of the New Zealand dollar.

However, we want to build in a risk premium, an acknowledgement that when the Kiwi moves it tends to move further, higher or lower, than anticipated. On this basis we’re looking for a level of about two standard deviations away from our fair value calculation, before thinking about adding to our foreign currency hedges.

We also need to acknowledge that our hedging decisions may not be right. Indeed, in some cases we may hedge too late, hedge too early or not at all, when we should have.

So why hedge dynamically, what’s wrong with “set-and-forget”?

At this stage of the global business cycle, a minimal level of hedge cover makes sense to us. Think back to the opening chapters of the Global Financial Crisis (GFC) – when the value of international shares, in general, plunged, as did the value of the New Zealand dollar.

Graph 2 displays the value of an international share portfolio denominated in USD and demonstrates over periods of acute stress (here we’ve observed the beginning of the GFC) that the decline in the value of an unhedged global share portfolio can be offset, to a certain extent, by the decline in the value of our currency.

Graph 2: movements in the value of a USD denominated international share portfolio and the New Zealand dollar.

Who knows how the current trade spat will pan out, or how Brexit will be resolved? As a risk mitigant, keeping foreign currency hedges to a minimal level makes sense to us.

Craig Alexander
Co-Head of Funds Management

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