Overcooked

The events of the last week reinforced the message that conditions for the New Zealand economy have softened since the start of the year. Yet the news hasn’t been all one-way, and indeed our assessment is that the ‘pulse’ of the economy has actually improved on balance in the last couple of months. We believe that financial markets are – once again – overestimating how much the ground has shifted for the Reserve Bank, and are under-pricing the odds of future interest rate hikes.

The twice-monthly Global Dairy Trade auction was the focus of attention last week, given the cumulative 40% fall in dairy prices since February (and the 17% drop in the previous two auctions alone). The latest auction showed some tentative signs of stabilisation in prices, with the trade-weighted index just 0.6% lower. Prices for whole milk powder, the main product in New Zealand’s exports, rose by 3.4%, the first increase since mid-June.

Of course, the latest result doesn’t make up for the surprisingly large price falls in previous auctions. We have revised our forecast of Fonterra’s milk price for the current season from $6.00 to $5.80 per kilo of milk solids. Even achieving this outcome relies on both a rebound in dairy prices by year’s end and a lower New Zealand dollar. That may seem like an unusual combination, given that the two tend to move in tandem over the longer term. But commodity prices aren’t the only influence on the NZ dollar, and there has been a notable turn in sentiment towards a stronger US dollar in recent times.

Some of the knock-on effects from the fall in dairy prices this year are beginning to show through. The Treasury’s Pre-Election Economic and Fiscal Update (PREFU) revealed a modest downgrade to the projections for growth and tax revenue compared to the May Budget. The outlook for a return to operating surplus from the June 2015 year remained intact, but the implication is that there is less in the kitty for any future spending (or tax cut) plans.