A steep fall in world dairy prices at auction last week sparked a flurry of questions from the market about whether a key part of the New Zealand economy’s goodnews story is coming unstuck. We would recommend cool heads for now: an easing in dairy prices in response to increased supply is something we have been expecting for a long while, although we are alert to the risk that prices could continue to fall.

Dairy prices fell 8.9% in the first GlobalDairyTrade auction for April, the biggest fall in a single auction in two years. While that followed a combined 9% drop in the two auctions in March, this was clearly the first time that it had registered on the market’s radar; up until the auction results, the New Zealand dollar had been powering ahead to new post-float highs on a trade-weighted basis.

The sudden downturn in prices seems to have generated a great deal of concern in markets about its causes, including whether it could signal something more sinister such as a steep drop in Chinese household demand. While nothing can be ruled out, the fact that the price drop seems fairly isolated to dairy products would argue instead for supply being the driver.

At the least, we can say that the scarcity premium is coming out of dairy prices. Domestic milk production is expected to be up 10% this season compared to the previous drought-afflicted season, despite very dry conditions again in some parts of the North Island. Meanwhile, European production is growing strongly, the trend in Australian production has improved in the last few months, and improved margins for American producers (thanks to higher dairy prices and lower feed costs) should see output increase there too this year. We have long been expecting dairy prices to soften in 2014 as the world ramped up production in response to the high prices on offer. But as the economist Rudi Dornbusch observed, in economics things take longer to happen than you’d expect, and then they happen faster than you’d believe.

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