What has changed with the New Zealand dollar?

The New Zealand dollar has long been considered a “risk on” currency. Investors expect that the New Zealand dollar will rise when share prices around the world go up – and sell off whenever we enter more volatile times in markets.

One of the drivers of this historical relationship was the carry trade. Many global investors speculated that the New Zealand dollar would hold up or rise despite higher interest rates in New Zealand compared to major economies in the world. Economic theory would suggest this should not happen and that a higher yielding currency should decline to offset the interest rate differential (the carry)¹.

The carry trade often benefited Kiwi investors hedging offshore currency risk. Hedging not only protected against a rising New Zealand dollar, it also added a premium from the carry as an additional sweetener². However, when the global financial crisis hit, the New Zealand dollar collapsed and fell by roughly 40%. As a result, unhedged investors had some protection against the fall in equity markets during that time. Although they were losing value on their offshore equities, they were gaining from their foreign currency exposure.

This is all well covered ground among investment professionals in New Zealand and it is common to see these basic relationships as the main justification of currency hedging advice. But here at Makao Investments we believe it is best not to travel forward by only looking in the rear-view mirror. Therefore, we asked ourselves, do these relationships still hold in a world in which New Zealand has lower interest rates than the United States?

Has the reduced carry hurt the New Zealand dollar?

The easiest way to start the discussion is to look at the relationship between the New Zealand dollar and the interest rate differential. Given the nature of the carry trade, one would assume that the New Zealand dollar moves in line with the differences in interest rates. We analysed this by looking at the NZD/USD exchange rate and the interest rate differential between New Zealand and the US (calculated as the New Zealand 90-day bank bill minus 3-month US LIBOR)³:

It is clearly visible that this relationship was quite strong in the early 2000s – until the end of the global financial crisis in 2008. Since then the dollar rebounded in value without an increase in the interest rate differential (2010-2014), plummeted without any significant decrease (when the milk price collapsed in 2015) and moved largely sideways since 2016 (during a period in which the interest rate differential steadily declined).

More generally, 2016 is where we “draw a line in the sand” for this analysis: The US Federal Reserve started to raise interest rates in December 2015, whereas the Reserve Bank of New Zealand did the opposite – and as a result from that time on the New Zealand dollar started to lose the carry.

Has the Kiwi dollar become less volatile?

The chart above also suggests that the Kiwi Is suddenly a lot more range bound. So, has the Kiwi been grounded and lost its ability to fly? Indeed, since the carry disappeared, the NZD/USD exchange rate has become significantly less volatile. However, this could be driven by a general decline in market volatility. It therefore pays to compare the NZD volatility to the volatility of equity markets (MSCI World):

For the most part, the volatility patterns were very similar over time. However, we can see that since 2016, the patterns have diverged – coincidental with the decline and disappearance of the interest rate differential.

Does foreign currency still provide downside protection for investors in New Zealand?

In light of the lower volatility and the decoupling from equity market volatility, should investors in New Zealand expect less downside protection from having offshore investments unhedged? Recent data suggests that the correlation between equity markets (MSCI world, in local currency) and the New Zealand dollar has indeed been impacted by the lack of the carry trade:

The impact of the reduced interest rate differential seems to be particularly significant for this relationship, with the correlation dropping more or less in sync with the declining interest rate differential. Could this be the end of the argument for downside protection from foreign currency exposure?

Hold your horses

History is littered with investors that got burned by relying on correlation numbers. As a result, we do need to take a closer look at sharp drops in markets before we throw the downside protection qualities of offshore currency exposure out of the window.

We took a closer look at the worst 3-day periods in equity markets over the last 15 years. We found that within the 50 worst drops, only four drops coincided with an appreciation of the NZD against the USD. However, we also found that the potential protection from a drop in the New Zealand dollar has generally been weakened in the periods after the European debt crisis in 2011.

The latest case in point was over the last week, when the fear of the spread of coronavirus hit equity markets hard. Even with New Zealand’s reliance on trade to, and tourism from, China, this did not result in a massive fall in the New Zealand dollar. It is fair to say that the NZD probably would have dropped a lot more 10 years ago.

We should not look at the Kiwi dollar with a blindfold on, however, so it’s worth considering how other currencies fared during the same period. What about the Japanese Yen, for example? The Yen is considered a safe haven currency and is expected to rise in a “risk off” scenario (i.e., move in the opposite direction of the NZD). What trends can we see in the correlation between the Yen and the global share market?

The two correlation patterns seem to be almost like a mirror image of each other for most time periods. The Yen/MSCI correlation has, however, not moved as much over the last four years as the NZD/MSCI correlation.

It is also worth pointing out that correlations were low for both of these currencies just before we hit the worst market environment in the last 50 years, the global financial crisis in 2008.

So where to from here?

Our analysis suggests that the disappearing interest rate differential has had an effect on the New Zealand dollar and its risk characteristics. The downside protection from foreign currency exposure might not be as significant as it has been in the past when the carry trade was on.

More importantly, however, we have to consider how different states of markets impact the relationship between asset classes and currencies. We might move back into a state of stronger correlations again at some point in the future, in particular if we enter a severe market shock, or if the interest rate differential increases again.

This is why it can be dangerous to forecast relationships between asset classes with a single correlation number informed by recent history. We should think about different states in the world, and how asset classes perform and interact in different environments, rather than trying to force everything into one (correlation) number.

This is exactly what we’re doing in our asset allocation model here at Makao Investments. We forecast different market environments in our model, and for each we use different relationships between each asset class to align with the non-linearity of financial markets and potential shifts in correlations.

Stay tuned for more information about our asset allocation model in our next thoughts piece. In the meantime, you may want to ask your adviser if your level of currency hedging is still appropriate now that there is little to no carry left in the New Zealand dollar.

¹ A good summary of why this is counterintuitive, and a useful discussion of the empirical work is the chapter “Why do carry strategies work?” in Illmanen, A., Expected Returns, 2011.

² For those who are interested in how this works in practice – and technically inclined – it may pay to read “The mechanics of currency hedging using forward exchange contracts, Johnson, A., Russell Communique, Q4 2013.

³ We note that there is still positive carry against EUR and JPY, however this differential has become smaller as well.

All data is to the end of February 2020 for a period of 20 years. Past performance is not necessarily a good indicator of future returns.