The EUR/NZD currency pair, which expresses the value of the euro in terms of the New Zealand dollar, seems to have established a tighter trading range in recent times (after a sharp rise and fall in the first half of the year). In my previous article covering EUR/NZD, I anticipated the potential for sharp short-term upside owing to an improved (higher) yield spread and reduced appeal in short-euro trades.
The daily candlestick chart below illustrates EUR/NZD price action; the vertical dotted line is set at the date of my previous article. Since then (June 17, 2020), EUR/NZD did indeed strengthen, however more recently we have seen weakness. The pair seems to be establishing a short-term trading range with little directional bias at present.
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
Perhaps the recent rise to the 1.82 handle, and the subsequent failure and drop, is indicative of “lower highs” relative to the peak in March (earlier this year) of almost 2.00. Lower highs typically help to support bearish trends. Yet as we have seen, EUR/USD has been climbing steadily, confirming my previous anticipation of euro strength. It is clear, at least to the present time, that the FX market has significantly reassessed the euro’s relative value upward.
However, since global sentiment is strong (at least, considering the challenging macroeconomic backdrop, in light of the COVID-19 pandemic), NZD has traded firmly; it is largely USD weakness that has engendered a stronger euro. In fact, if we look across the FX space, most EUR FX crosses indicate limited euro strength (besides EUR/USD). With such limited breadth, perhaps we should start to consider the possibility of a weaker euro across the board. Limited breadth in this case essentially means that while EUR/USD may be climbing, other currencies (besides EUR) are climbing even faster against USD, and so perhaps the upside in EUR/USD is far less exciting than it seems.
EUR/USD is the most liquid and heavily traded currency. In terms of the currency distribution of over-the-counter foreign exchange turnover, recent data indicates that USD participates in a massive 88.3% of average daily FX turnover (April 2019), while the euro comes in second at 32.3% participation (second place). Other popular currencies include JPY, GBP, AUD, CAD, and CHF (altogether representing the G7 nations). NZD is more thinly traded; while part of G10 foreign exchange, NZD participates in about 2% of average daily turnover (again, per April 2019 data released by the BIS).
While EUR is liquid, NZD is subject to sharp movements owing to its reduced liquidity. Some have complained about reduced FX turnover in GBP FX crosses owing to risks such as Brexit (attracting fewer direct spot-market participants). However, GBP still represented 12.8% of average daily turnover in April 2019, about 6x as much as NZD’s share. This is one simple explanation for the extremely sharp one-day rise (as shown in the chart above) which occurred on March 19, 2020, as traders placed significant pressure on the market for NZD.
This was one of the risks I believed NZD was still possibly subject to, but since markets seem to be functioning much more satisfactorily since the first half of the year, it would seem that there is no immediate risk of a sharp NZD sell-off on the horizon. It does make sense for EUR/NZD to be taking a softer stance with more “range-bound” trade.
Yet thinking longer term, EUR/NZD could be viewed as undervalued. Using the OECD’s Purchasing Power Parity model data, and running price data for EUR/NZD, we can see that EUR/NZD seems to be trading at a price that is on the low side relative to its relative purchasing power.
In the chart above, the red line in the center of the chart indicates the EUR/NZD PPP fair value estimate. The black line represents price action, while the lower and upper bands are based on a 30% delta with respect to the PPP value. As we can see, price rarely moves beyond (or far beyond) 30% above or below the PPP value (based on OECD’s model). While we do not yet have a figure for 2020, we can compare the current price (at the time of writing) of EUR/NZD of 1.75 and divide it into the 2019 PPP estimate of 2.06 to determine a possible undervaluation of 15% (about half of the “expected” limit).
This might not present us with an especially strong bias, but the bias is clear: EUR is probably undervalued relative to NZD. With New Zealand being a small economy interested in its commodity exports, and the euro area representing one of the largest economic powers in the world, this might suggest that New Zealand can expect to enjoy some trade tailwinds over the medium to long term. We can also see that the terms of trade for New Zealand have risen in recent times. Germany has also benefited from recent changes in export and import prices (worthy of note, since it is the largest country in the euro area).
(Source: Trading Economics.)
Other major nations such as France have also benefited. Both the euro area and New Zealand have benefited from lower oil prices given that they are both net oil importers.
Both EUR and NZD look fairly well positioned in this case, but we have to remember that the European Central Bank are unlikely to escape negative rates for a long time (the deposit facility rate remains negative at -0.50%). New Zealand’s rate remains at +0.25% following a cut of 75 basis points earlier this year. Provided New Zealand does not cut to zero (or lower), NZD is clearly a nicer currency to hold. Negative rates are almost like a tax on liquidity, and as such there is a clear negative bias, since continued intervention is needed to ensure liquidity remains high.
NZD is not there yet, being in positive interest rate territory. We might also be able to argue that there is a stronger potential for NZD rate hikes versus EUR rate hikes (in future), which would provide us with a positive outlook for NZD. This probability of a future rate hike (NZD rate outperformance) is helped by a stronger EUR/NZD rate too (the rate may be volatile, but has generally trended upward since Q2 2015), since the Reserve Bank of New Zealand might otherwise be tempted to “back off” from a rate hike were NZD too strong. Further, with risk sentiment largely positive, riskier currencies like NZD can find some strength.
Therefore, the issue really comes down to confidence. As noted in a recent article of mine, the euro has not received much approval from markets since its inception (most trading at a discount relative to GBP, for instance). Sentiment has been more mixed versus NZD, but the question is whether stronger euro area integration (through the bond market and coordinated fiscal policy to tackle the pandemic and its aftereffects) will help to improve EUR sentiment. And whether this improved sentiment will be enough to counterbalance strong NZD sentiment (a currency which seems relatively well-positioned for further upside).
EUR/USD may have risen, but given lower breadth among EUR FX crosses, perhaps a stronger EUR/USD rate is not indicative of truly positive sentiment. The chart below shows EUR/GBP, EUR/CAD, EUR/AUD, EUR/CHF, EUR/NZD, and finally EUR/USD (the last pair shown by the thicker black line). The break out in EUR/USD has not been supported by these other pairs this year.
Without clear support from the market, I believe EUR/NZD is priced close enough to its long-term fair value that we should see New Zealand benefit from an economic perspective (perhaps New Zealand’s trade deficit with the EU will fall), but also see EUR struggle to gain much further ground. The U.K. trade deal deadline (with the EU) also remains in sight at 2020 year-end, which presents another risk to near term EUR stability.
New Zealand was also growing much faster than the euro zone prior to COVID-19, and did not suffer as much in Q1 2020. We will need to watch for further data, but New Zealand may indeed benefit from FDI (capital inflows) going forward, which were positive even in Q1 2020.
Admittedly, EUR/NZD may be somewhat undervalued based on our PPP model. Yet confidence matters more than anything (which is why currency pairs do not simply “hug” their long-term PPP values). The “dance” we see around “fair value” represents capital flows (in/out), which are based principally on confidence (in one catchall word). Broad confidence does not actually seem to be present yet for the euro, and as such I do not expect the euro to attempt a break out versus NZD.
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.