FX Watch – El Niño and commodity FX

by: Georgette Boele , Roy Teo

The chance of an El Niño weather event is high, but it will likely be a weak to moderate one. If an El Niño shock were to occur, some regions will experience deviations from their normal weather patterns. This can have material effects on their economy. Policymakers are likely to respond should these effects endanger their policy targets. The central banks of Australia and New Zealand are likely step up monetary policy easing and this will weigh on the Australian dollar and New Zealand dollar. The South African rand is unlikely to be sold off aggressively because of a vigilant central bank. However, Latin American currencies will probably benefit because of higher interest rates and stronger growth.

 

El Niño weather phenomenon attracting attention

The possibility of an El Niño weather phenomenon (see box 1) occurring this year has attracted attention. This is because if an El Nino shock were to occur, the impact on some economies and commodity prices (especially agricultural prices) could be significant.

El Niño explained

El Niño is a natural phenomenon caused by unusually warm ocean temperatures in the Equatorial Pacific, that leads to significant deviations from normal weather patterns. In particular, El Niño can lead to a disturbance in rainfall patterns. The lead time between measured unusual water temperatures and disturbed weather patterns can be as long as one year.

Among these consequences is increased rainfall across the southern tier of the US and in Peru, which has caused destructive flooding, and drought in the West Pacific, sometimes associated with devastating bush fires in Australia. Observations of conditions in the tropical Pacific are considered essential for the prediction of short term (a few months to 1 year) climate variations. El Niño can be seen in measurements of the sea surface temperature

Source: National Oceanic and Atmospheric Administration (NOAA)

Chance of El Niño occurrence is high, but a weak to moderate one…

According to US NOAA Climate Prediction Center there is an approximately 90% chance that el Niño will continue through Northern Hemisphere summer 2015, and a greater than 80% chance it will last through the end of 2015. By early May 2015, weak to moderate El Niño conditions were reflected by above-average sea surface temperatures across the equatorial Pacific.

What is the impact of El Niño shock on real GDP and inflation?

According to an IMF Working Paper, Fair Weather or Foul? The Macroeconomic Effects of El Niño, April 2015, an El Niño event has a significant effect on real GDP growth for most countries in the sample (the countries below including Argentina, Malaysia, Philippines and Saudi Arabia). While Australia, Chile, Indonesia, India, Japan, New Zealand and South Africa face a short-lived fall in economic activity following an El Niño weather shock, the US, Europe and China eventually benefit from such a climatological change.

In addition, most countries experience short-run inflationary pressures following an El Niño episode (see graph below).

 

What does this mean for our outlook of commodity currencies?

If an el Niño shock were to occur and its effects are in line with the above mentioned IMF study, what does this mean for our outlook of commodity currencies? This can only be determined by combining the impact on GDP and the impact on inflation,  because they will be crucial for setting monetary policy (see graph below) and the direction in the currency.

More monetary policy easing in a number of countries…

It is likely that the central banks in Australia and New Zealand will ease more aggressively this year and/or have a longer easing cycle to support their economies in case of an el Niño shock. Adverse weather effects will affect food and agricultural output in both countries and weigh on growth. The impact on the New Zealand economy will be more substantial. Therefore, the central bank may ease more aggressively. The prospect of a weaker economy and more monetary policy easing (because of low inflation pressures) will add further pressure on the Australian dollar and the New Zealand dollar in our view. As a result, it is likely that they will fall further than currently is reflected in our current currency forecasts.

…however the SARB will unlikely ease …

Despite weak economic growth in South Africa, inflationary pressures persist. It is likely that the South African Reserve Bank (SARB) will hike interest rates at their next meeting. In the occurrence of an el Niño shock, the drop in economic growth will unlikely result in rate cuts because inflationary pressures remain because of upward pressure in power costs. Therefore, the central bank will probably continue their current vigilant stance. This will continue to have a negative effect on economic growth.

During the Fed tapering dry-run, the rand belonged to the group of fragile five currencies that weakened sharply when financial markets upward adjusted Fed rate expectations. This year, we expect another wave of US dollar strength based on expectations of higher US rates and yields. However, we expect the rand to be more resilient than in the past. Granted the South African current account deficit remains substantial at 5% of GDP (see graph below). Therefore, the rand remains vulnerable to changes in investor sentiment. However, the current account deficit is on an improving trend. Moreover, a small portion of debt is foreign denominated and foreign reserves position are stable at comfortable levels. This will increase the resilience of the rand. In addition, it is likely that a vigilant central bank will gain market confidence despite weak economic growth. Last but not least, the rand is massively undervalued. So the occurrence of an El Niño shock wills unlikely result in a change of our USD/ZAR forecasts.

…while other central banks could become more restrictive

Even though an El Niño shock will probably bring higher economic growth in Brazil, Mexico, Chile (according to this IMF study), it will also bring higher inflationary pressures. The combination of higher growth and inflation, may push interest rates in Brazil higher. However, monetary policy is already very restrictive and we judge that most of the hiking cycle is behind us.

For Mexico and Chile, a combination of higher growth and higher inflation could trigger an earlier start of a hiking cycle. A combination of higher growth and higher official rates should be supportive for the Brazilian real, Chilean peso and Mexican peso. However, they will unlikely outperform the US dollar as we expect the US Federal Reserves to hike more aggressively than currently is reflected in prices.