Kiwi: The Next Long or is it Just a Short Squeeze?

Kiwi: The Next Long or is it Just a Short Squeeze?

Following my prior trade setup on the Canadian dollar, I see a possible opportunity to long another commodity currency.

NZD My Favorite Pick

RBNZ hiked OCR(interest rate) by 25 bps to 0.5% from 0.25 in its latest meeting OCT 6. Meanwhile, it maintained its hawkish bias and tendency to continue to tighten further as time progresses. Hence, any positive economic data should support this view, and since inflation is above the bank’s target. The market is expecting the bank to move sooner than later.

Quoted from the latest statement on OCT 6,

The Committee noted that further removal of monetary policy stimulus is expected over time.

Last week, the spike in inflation in New Zealand significantly lifted the expectations for another rate hike soon from the RBNZ. The rise in inflation came well above market expectations and the central bank’s medium-term target of 2 percent. CPI for the third quarter jumped from 3.3% to 4.9% year on year, well above market expectations of 4.1%. While quarterly CPI rose to 2.2 percent, 0.8 percent above market expectations of 1.4%.

The central bank expected this near-term rise of inflation above 4 percent in its meeting. Also expected the rise is transitory. So if the rise in inflation was expected, why the numbers were important? and why they triggered a rally?

There are some key factors to take into consideration:

In its latest minutes in OCT 6, the RBNZ:

“The economy hitting capacity constraints given the effectiveness of Government support and resilience of household and business balance sheets. While some capacity bottlenecks are likely to be short term, there is a risk that these become more persistent as we transition to a COVID-19 endemic state of the world. The Committee agreed that rising capacity pressures would feed through into inflation. Employment is expected to remain at around its maximum sustainable level”

In other words, the labor market is tight(full capacity) and capacity pressures persist. The economy and labor market nearly functioning at full capacity. This basically means In simple terms, production is limited due to insufficient resources and logistic issues. Meanwhile, demand is stable.

While some capacity bottlenecks are likely to be short term, there is a risk that these become more persistent as we transition to a COVID-19 endemic state of the world.

I believe, traders are underestimating and maybe overlooking this. The fear that the current constraints on supply output may be persistent is a major thing. An indication that an inflationary environment is here to stay maybe for longer than expected.

In this context, the latest CPI spike close to 5 percent- not a mere marginal rise above 4%- caught markets by surprise.

The persistent rise in commodity prices is a strong part of the story. And the recent rise in commodity currencies including the NZD. Furthermore, it feeds into the idea of a longer-than-expected inflationary period.

The key question to ask now is, would economies be able to ease supply constraints in the near term to curb the inflation feedback loop(inflation creating more inflation). I would say that may happen over time but not in the very foreseeable future. Also, the ability to do so is different from one country to another as many factors play a role in this. Such as current spare capacity levels in the economy. In addition to the nature and structure of the country’s economy.

Whether this scenario materializes or not in the long run, inflation should remain elevated in the short run and the case for relatively stronger commodity currencies is probably valid and hasn’t been fully priced in, at least in the short term to medium term. Especially against economies lagging on the economic front and monetary policy like Europe.

Factors in favor of a stronger NZD:

  • A hawkish central bank(biased to raise rates).
  • Higher commodity prices(Commodity producer/exporter).
  • U.S Dollar quantitative easing tapering has been priced in.
  • Risk-off mode, strong equity markets.
  • Global inflationary environment, hence capital search for higher yield.

One factor that goes against my bias is the lag in 2-year bond yield differentials. The NZ and Australia 2-year bond yields are underperforming other developed countries like the U.S., Canada, and the UK. However, these divergences are short-term and may adjust quickly.

But the euro story is different. The differentials are not in favor of the currency. In fact, the recent bullish bounce in EURUSD wasn’t confirmed by the 2-year bond yield differential. Having that in mind I prefer to long the NZD against the euro.

aud and nzd  yield differential against the us
Australia and NZ yield differential against the US
eurusd yield differential
EU/US 2-year yield differential diverging

The Trade Setup: EURNZD Could be a BIG Short

The euro fundamentals remain bad. The central bank is dovish at best case is neutral as economic growth and labor market largely underperform New Zealand.

From a technical perspective, the pair has been trading in a long-term bear trend. Recently broken a major long-term horizontal barrier(support) around 1.63, yet the break is intra-week so far. Therefore, I will wait to see the week closes below this support.

eurnzd weekly chart
EURNZD weekly chart

Next week, I will be looking at the daily and four-hour charts for entry confirmation. i.e. a bearish reversal candlestick pattern (ex. shooting star) or a double top pattern on the daily or four-hour time frame to initiate a short.

eurnzd daily chart
EURNZD daily chart

My area of interest to short is among 1.6300-1.6350. Which is the confluence of the most recent weekly swing low and the 23.6% retracement of the latest bearish wave as shown on the daily chart above.

I am looking for a first target near the 1.27 Fibonacci extension for the latest bullish correctional wave -as shown on the weekly chart- around 1.61 and a second target at the 161.8 extension, at 1.5800.

Lu'ay Af.
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Lu'ay Af.
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