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The Wrong Dollar Is Collapsing

Chip Hanlon

Although the New Zealand dollar is oversold, the recent plunge shouldn't be taken lightly.

Wasn't it the U.S. dollar that was supposed to fall apart? The twin deficits, the empire of debt, the rise of China -- all of that was supposed to bring on calamity.

So why is it the New Zealand dollar that has fallen out of bed recently?

Take a look at what the kiwi has done since the start of the year.

Even while the CRB index rallied in March to get back on the plus side for the year, the decline in this "commodity currency" picked up steam. It's now off more than 10% for 2006.

Sure, in the last couple of days the U.S. dollar has stumbled and many foreign currencies have bounced nicely as a result, including the yen and the euro, but the New Zealand dollar has hardly budged.

So what's going on? Rising interest rates in the world's largest economies are starting to impact the kiwi in a number of ways.

First, as I wrote in January, if the U.S., Japan and the European Union are tapping the economic brakes, there is likely to be a negative trickle-down to the commodity economies of Canada, Australia and New Zealand; it may already be affecting these places.

If so, New Zealand is particularly at risk because it's not a commodity economy rich in energy resources, metals and other industrial raw materials, as are Canada and Australia. New Zealand has benefited greatly from the perception that it is, but investors may be surprised to learn that more than 50% of its exports are still related to agriculture. Not that agriculture is unimportant, but it doesn't quite square with the theme of feeding China's voracious industrial appetite, which some investors believe they're tapping by buying exposure to New Zealand.

Second, despite the fact that it still maintains the headline claim of having the highest interest rates in the developed world, the kiwi's yield advantage is quickly evaporating. The recent signal from Japan's central bank that it will begin slowly tightening threatens to reduce a major capital source for New Zealand, the yen carry trade. It also could reduce retail interest from U.S. investors.

Indeed, the yield advantage from one important U.S. source is already gone. Over the last few years, while U.S. rates were especially low, Everbank, a small Midwestern concern that has found success marketing unique CDs denominated in foreign currencies, has seen its New Zealand-denominated offerings thrive. Now, however, that product's yield advantage has vanished completely. After factoring in the bank's hefty 0.75% fee for simply converting one's currency (an astounding 1.5% round trip), the 5.75% interest offered on its three-month CD, its highest-yielding New Zealand product, nets out only to 4.25%, less than many current U.S.-denominated CDs of similar durations. (To its credit, Everbank has recently been warning its investors away from the New Zealand dollar.)

Finally, the "commodity economy" theme seems to have caused a lot of investors to forget that New Zealand is a nation that's roughly the size of Colorado, has only two-thirds the population of tiny Israel and boasts an economy that by GDP is ranked 42nd by the World Bank, just ahead of Colombia and Pakistan. The point is, if its once-heralded yield advantage is disappearing, the currency of such a small economy could be especially prone to being clobbered by capital flows when they start to go in the wrong direction.

From a long-term standpoint, look at a technical development on the following three-year chart that also has me worried about the kiwi:

According to the short-term indicators above, there's little doubt that the kiwi is now oversold, but any bounce is going to meet formidable resistance back up in the high 60s and stands a very good chance of completing a huge, multiyear head-and-shoulders top. Technically, the potential exists for a multiyear round trip in this currency all the way back down to the mid-40s.

The U.S. Dollar vs. The Kiwi

Some readers may be thinking, "Wait a second ... didn't this guy just write that the U.S. dollar was making a head-and-shoulders top? If so, shouldn't we expect the dollar to fall and foreign currencies to rally?"

In the short run, sure. Here's how I'd suggest squaring the two thoughts:

First, I do think the U.S. dollar is trading poorly at present, most likely because the market is factoring in an end to the Fed's tightening cycle. Regardless of when the end comes, investors are no longer bidding up the greenback based on continuing interest rate hikes. If the kiwi is able to find some footing and bounce, however, at this point I merely expect it to fulfill that right shoulder as outlined above.

Meanwhile, any advance in foreign currencies might coincide with yet another head-and-shoulders pattern that can't be ignored, as this 10-year chart of the dollar highlights:

I'm convinced from day-to-day trading activity in and around nondollar assets that there remains little faith in the U.S. dollar. It won't take much of a pullback to turn sentiment wildly bearish and make the dollar permabears popular once again (perhaps for the last time). Such a washout just might coincide with a broad, multiyear head-and-shoulders bottoming pattern in our currency.

Bottom line: If the U.S. dollar shows weakness later this year, fight the urge to get caught up in the apocalyptic gloom and look closely at using any such opportunity to lighten up on a currency like the New Zealand dollar in favor of the greenback.