GDT 188: Weak but good

The last auction result (+3.6%) was right at the top end of my expectations (+/-3%) and WMP was +5.2% but there has been limited follow through since in the futures market.

The result reinforced expectations for a final price for the current season slightly above $6.00 (the 2016/17 futures have strengthened from $6.05/kgMS to $6.11/kgMS) but since the last auction the 2017/18 futures price has weakened from $6.25/kgMS to trade at a discount to the current season at $6.00/kgMS.

12 months ago (at the equivalent auction) WMP priced at $2,252/tonne and with a spot kiwi value of USD67.62 cents, my “ready reckoner” forecast a season price (on that basis) of $4.20/kgMS compared with a season opening price by Fonterra of $4.25/kgMS.

As we enter this season, the WMP current “spot” price of $3350/tonne and “spot” kiwi of USD68.62 in isolation, suggest a season ahead closer to $7.00/kgMS. However, the current forward curve for WMP is in backwardation (ie. longer dates are at lower prices) and the kiwi dollar has averaged closer to USD72 cents over the period in which Fonterra will have been pre-hedging next season. Hence “spot” price calculations are somewhat misleading. Using a new season price of $3,050/tonne (as is currently priced) and using an averaging process to determine the relevant currency suggests a current new season price of about $6.20/kgMS compared with the current futures price of $6.00/kgMS.

Based on current pricing of WMP, June – October contracts are currently lower than the last auction results by 4% - 9% and WMP prices could come in -5%, although they will hopefully hold the $3,000/tonne level. SMP prices are more mixed with some contracts trading -5% to the last auction results while others are trading +5%.

On balance and notwithstanding lower auction volumes (which could add volatility) on balance, indicators point to an auction result this week some 5% weaker than the last auction although the distortions in the curve don’t give me a high degree of confidence in this forecast.

The broader commodity complex:
It is worth observing that broader commodity prices have been weaker in recent weeks. Iron ore has continued its significant correction and this, together with weak wages and retail sales numbers in Australia, has weakened the AUD. Coal prices have hung in at higher levels supported by export disruption following Cyclone Debbie while oil prices have traded within a range but with little excitement about an upward price move as we enter the northern hemisphere summer.

Compared with these other commodities, dairy prices have been relatively robust.


RBNZ Monetary Policy Statement:
Locally this week the focus was on the RBNZ Monetary Policy Statement. The local market was focused on expectations that the RBNZ would bring forward its projection of a rise in the OCR. The market was somewhat “disappointed” that the RBNZ remained “dovish”. Clearly, the RBNZ sees the prospect of US rate rises (see my last note) as being a positive for NZ exporters (via a potentially weaker NZD). The RBNZ has stopped “jawboning” the currency suggesting that they may feel that they have a tail wind for the first time in some years.

While the market has focused on the RBNZ’s central view, the most interesting chart in their statement, in my view, was the one below. This suggests that if the economy has greater capacity constraints than currently visible and this is exacerbated by further construction demand, a rate rise could occur before the end of this year (although the OCR doesn’t rise above 2.375% over the projection period). However, it also notes that if construction activity is lower than projected (perversely due to higher prices and tighter credit constraining activity levels), the OCR could conceivably be cut [while theoretically possible I personally believe that this is unlikely]. Whatever scenario is realised, the RBNZ projections suggest an OCR “range of possible outcomes” of 1.625% - 2.375% over the forecast period. This remains very low relative to historical levels and to projections from prior to December 2015.

Consistent with these very moderate interest rate expectations, the RBNZ forecasts incorporate a trade weighted exchange rate index (TWI) to weaken by 3% (year on year averages) or 5% (point to point) over the forecast period. This outcome would be largely generated by relative interest rate forecasts that sees the Federal Reserve (not market) US interest rate median projection over the forecast period rising by 1.5% compared with the RBNZ median projection of just a 25 bp rise.

The combination of lower than expected US bond yields and the dovish RBNZ outlook has seen interest rates in NZ range trading since the beginning of the year with a slight bias to lower rates. I have included a chart of 5 year swap rates. After a sharp move higher in the 4th quarter last year, 5 year swap rates reached 3.15% over the Xmas period. This morning they are trading at 2.75%, towards the lower end of the trend channel. This probably represents a reasonable hedging level. I would note, however, that most banks have been reviewing their credit margins and these need to be added to the relevant swap rates.


Fonterra Australia – the pain continues:
Under the Bonlac Supply Agreement, Fonterra was obliged to match farmer payments by Murray Goulburn. The decision by the later to make good on an effective $5.53/kgMS payment for last year and dump the debt clawback it had put in place has left Fonterra (after taking advice) having to match this decision. Fonterra is reported to be intending to make the payment to farmers via the 2017/18 milk payments. This faces a legal challenge from farmers who have switched supply since 2015/16 (reportedly 80-100 farmers) and may also be challenged on grounds of transparency. This is another PR and financial challenge for Fonterra Australia largely bought on by Murray Goulburn’s actions and poor management. 

The MKP futures market for 2017/18 is now the focus of traders and hedgers and this has weakened 4% since the last auction. Similarly, notwithstanding resilience in the May contract price, most WMP contracts are trading lower than they were going into the last auction.

Dairy prices have also proved more resilient than other commodities in recent weeks and the interest rate and currency dynamics have also been generally favourable. Hence the current situation and the outlook are far more positive than this time last year despite, perhaps a weaker result expected with this auction.