Auction 184 - finding a base?

SUMMARY:

  • Based on current price activity in the futures market, this week’s GDT auction looks likely to deliver a further fall in prices but in the 3%-5% range compared with the 5%-7% being priced a week ago.
  • The demand-supply balance is key to market pricing. The market has been set back since mid January with higher than expected production in NZ, Australia and Europe 
  • $6 still for 2016/17 but $5.25 to $5.75 for opening price for 2017/18.
  • Beware rising interest rates.

Auction 184

After a couple of false attempts to call a market pull back in Auctions 181 and 182, we got the catch up in Auction 183. 

We saw pull backs in most product categories but it was SMP (below) with a 15.5% pullback which led the weakness having surprised in previous auctions, maintaining a significant premium over European and US prices.

Post Auction 183 we saw further weakness which took prices off about another 5%-7% (as shown below) before some buying interest reappeared. Although it was not all one way, markets stabilised late last week with WMP finding support just above $2,600/t and SMP finding support just above $2,000/t. A further hurdle was passed when Fonterra announced no change to previously announced volumes to be offered, although there has been some juggling between contract months. As previously announced, there is a higher volume of WMP being offered in this auction comapred with the previous auction and that is still creating some nervousness in trading yesterday and again this morning with April and May contracts better offered.

Based on current price activity in the futures market, this week’s GDT auction looks likely to deliver a further fall in prices but in the 3%-5% range compared with the 5%-7% being priced a week ago.

SMP Pricing (pink) versus WMP pricing (yellow):

The demand-supply balance is key to market pricing. The market has been set back since mid January with higher than expected production in NZ, Australia and Europe albeit all markets are still seeing YoY declines in production. With prices in all these markets higher than 12 months ago, the sense is farmers remain keen to increase production in the near term and into next season.

Declines in Oceania and European output have been partly offset by continued growth in US supply (+2.5% YoY). US growth is expected to continue into next season with the highest cow numbers in 20 years being reported, lower cull numbers and milk over feed margins not far from $10/cwt….well below the $13/cwt of 2014 but above every other year over the last decade!

Broad Based Commodity performance:

You are justified in feeling disappointed in the performance of dairy prices through the first 3 months of the year! Overall, commodities as an asset class have been the worst performer, under-performing even fixed income (bonds) and significantly under-performing the equities market as illustrated below. The commodity performance has been impacted by weakness in oil prices but not exclusively so. The oil price performance has been a disappointment because the OPEC supply agreements have largely held. A little like dairy, the swing supply has come from the US market with shale producers upping production. Despite the distraction of Trump, US producers of stuff are doing a good job (witness the number of Mustangs on the roads in Australia and NZ – and while they look and sound good they don’t really go around our corners that well!!)

Most analysts are expecting a somewhat improved commodity back-drop to the remainder of the year. The dovish Federal Reserve announcement (notwithstanding the rate hike) and the accompanying USD weakness should assist but it is a fine balance!

FX and interest rates:

This week we will see the latest RBNZ OCR. No change in the cash rate is expected. Indeed the RBNZ is forecasting no change until 2019. As improbable as this would seem, the RBNZ stance is understandable as the US gets into stride on its tightening cycle.

At the beginning of the year I suggested that the NZD would struggle to get above USD72.5 cents and it almost immediately proved me wrong as Trump talked down the USD. However the NZD has subsequently moved back to the lower end of the range and a break below USD68.5 cents would suggest lower levels still. The RBNZ should remain focused on the fact that interest rate differentials will be the main catalyst for a move lower – which they would like as it would assist export receipts and assist them in moving the CPI solidly back into their target range!

The two charts below are the tale of NZ and US rates (5 year NZ swap rates and 5 year US Treasury bond rates as the most liquid benchmarks). NZ rates were reduced steadily between 2010 and 2012, but playing “catch up” with already reduced rates. Despite this falling rate environment, the relatively higher NZ rate structure supported a strong kiwi dollar. That strength was then sustained when the RBNZ decided to tighten rates on 4 occasions through late 2014 and into 2015. The reversal of that stance saw RBNZ lower the OCR to new lows and the kiwi steadily retreated. While NZ rates have risen in sympathy with recent US tightenings, you can see from the chart below that we have really only reversed the last part of the rate move down and while it would seem that the RBNZ is not yet in tightening mode, both the OCR and 5 year NZ swap rates (as illustrated below) remain at extremely low levels by historic standards and it would seem further upside pressure is likely as monetary policy “normalises” in the US and potentially in Europe in the second half of the year.

This should be born in mind by a highly leveraged household and rural sector.

NZ Interest rate track:

US interest track:

Conclusion:

  • The market has attempted to find a base in the last 2 weeks and while we would expect to see some further weakness tonight based on futures pricing, we hopefully won’t see “unexpected weakness” (ie. a downside move of >5%).
  • Market pricing is suggesting a $6.00/kgMS payout for the current season (futures last traded at $5.95/kgMS) and early indications of $5.25-$5.75/kgMS for next season (futures last traded at $5.68/kgMS) although we know that these pre-season predictions are perilous. Certainly the prospects (at this stage) of a season payout in the mid $6 range that existed when WMP was trading at $3,250/t have evaporated and prospects for a strong rebound from this latest move before Q3 look poor.  
  • As noted above, the current NZD trading and interest rate stance from the RBNZ remain supportive but the latter, in particular, does not look sustainable medium term so balance sheet positions and hedging should be considered in that light.