The NZD/CAD currency pair, which expresses the value of the New Zealand dollar in terms of the Canadian dollar, has pushed and pulled this year, but ultimately NZD has recently found itself precisely back to where it started the year. At the time of writing, NZD/CAD trades at the 0.87 handle, though recently the pair has been making lower highs, and risks registering a lower low in the near term (below its August lows at the 0.86 handle).

NZD/CAD Price Action in 2020(Source: TradingView)

Both NZD and CAD are commodity currencies. This is because New Zealand and Canada are both commodity exporters, and therefore while these countries’ current accounts are not usually in surplus, their currencies tend to fluctuate in accordance with global commodity prices. When the global economy is performing well, and businesses are booming on the back of supportive consumer sentiment, global commodity demand tends to also be higher than average. As a result, NZD and CAD usually find support by virtue of this favorable economic backdrop.

However, when economic sentiment wanes, NZD and CAD struggle as risk-off moves punish commodity currencies. As COVID-19 emerged, which ultimately created a widespread financial crisis this year for many businesses as consumer spending and business investment ground to a halt, NZD and CAD sold off heavily. Following significant fiscal and monetary interventions globally, risk sentiment has returned. Yet while equities may have subsequently reached all-time highs after crashing in Q1 2020, the economic after-effects of this year’s crisis have not vanished. Uncertainty is still abound.

The question therefore is, which currency is better positioned for the future; NZD or CAD? While both share some core characteristics, New Zealand is a much smaller nation than Canada. As reported by the OEC, Canada’s annual GDP totaled US$1.71 trillion in 2018, while New Zealand‘s GDP totaled US$205 billion (about 12% of the volume of Canada’s GDP). The OEC also analyzes economic complexity of nations; larger nations with more diversified industrial (and service) bases tend to score more highly than the smaller, more focused economies. Canada ranks 25 out of 137, whereas New Zealand ranks at 49.

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Because New Zealand is smaller, and its economy less sophisticated, NZD is generally a riskier currency to hold versus CAD (all else equal). This will be in part why the initial sell-off this year favored NZD/CAD downside. It also helps to explain why the subsequent rebound helped to support the NZD/CAD exchange rate. However, NZD/CAD also registered a substantially higher reading after its initial crash this year. As shown in the chart at the beginning of this article, prior to the start of this year NZD/CAD almost hit the 0.88 handle. In July this year, NZD/CAD briefly hit the 0.90 handle.

These higher highs have been enabled by two reasons: firstly, lower oil prices this year (crude oil futures still trade about a third lower than late-2019 levels) have supported New Zealand’s relative to terms of trade. Terms of trade indexes reflect movements in the ratio between countries’ export and import prices (higher is more favorable). New Zealand is a net importer of crude oil products, whereas Canada is a net exporter. The negative overall change in crude oil prices this year has undoubtedly favored NZD/CAD upside.

NZD/CAD Terms of Trade Differentials(Source: Trading Economics. New Zealand terms of trade shot up this year, while Canadian terms of trade has done the opposite.)

Fortunately for Canada, however, oil prices have managed to rebound significantly off this year’s lows. Therefore, much of the collapse in Canadian terms of trade has now been retraced (as shown by the black, dotted line in the chart above).

Another change is the fact that risk sentiment has returned with strength, supporting equities and other risk assets, plus commodity currencies.

It is worthy of note that USD, a traditional safe haven, has more recently weakened considerably versus CAD. Therefore, even CAD has strengthened significantly relative to this year’s lows, although the weaker state of the oil markets this year (a weaker state which persists) has meant that USD/CAD has only fallen back to levels seen in January 2020 (not yet below). NZD/CAD has already managed to surpass its late-2019 high, as mentioned previously.

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Another factor is interest rates. The Bank of Canada’s target rate has been slashed from +1.75% to just +0.25%, while New Zealand has cut its rate less, from +1.00% to +0.25%. However, it is also important to look at inflation. The chart table below uses inflation data for New Zealand (quarterly) and Canada (reported monthly) to adjust these countries’ central bank rates to find an implied real yield (if we assume central bank rates ultimately feed into funding market rates successfully).

NZD/CAD Real Yield Spread Change(Source: Author)

This simple analysis shows that the change is in fact unfavorable for NZD/CAD. A drop of about 0.5% in the implied real yield has occurred from the start of the year to the end of the second quarter. Canada’s more recent monthly inflation data also indicates even lower inflation at just +10 basis points year-over-year.

Tourism is also important to New Zealand; as I wrote recently, the tourism sector is responsible for employing about 20% of jobs in the country. Tourism is a factor to be concerned with globally, but New Zealand is one of the most exposed. For Canada, tourism only represents around 2% of GDP.

As COVID-19 restrictions continue, and as we head into the winter months amidst a second wave of this disease, it is unlikely that tourism will bounce back significantly in the short- to medium-term. As a result, NZD is likely to struggle to sustain its higher prices versus CAD. On the other hand, another collapse in oil prices would certainly help to buoy the NZD/CAD rate. Still, this is not a base case, and as of October 17, 2020 it appears that Russia and Saudi Arabia are now on better terms with respect to oil diplomacy. If oil can at least remain steady, even at these lower levels, NZD/CAD is probably going to struggle to sustain its current levels.

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One final model worthy of sharing is a Purchasing Power Parity model, which helps us to assess the probable fair values of currency pairs based on the two currencies’ relative international purchasing powers. I construct the chart below using the OECD’s PPP model data, introducing upper and lower bands which deviate from the rolling annual fair value estimate by 30% (to contextualize highs and lows, and the current price).

NZD/CAD Purchasing Power Parity Model in 2020(Sources: and OECD)

NZD/CAD, since about 2014, appears to have traded fairly close to the PPP-implied fair value estimate. It is nevertheless still probably overvalued, which suggests that our overall bias should be negative. This would complement our findings that the implied real yield for NZD/CAD has worsened this year, while New Zealand also remains more exposed to the after-effects of COVID-19 (via tourism) provided that crude oil prices do not sink materially over the medium term. Since consumers are less likely to be afraid to travel nowadays, oil demand is probably going to support current prices, and yet reduced demand for international travel may remain lower for longer. This combination could certainly drive NZD/CAD lower over the medium term.

I would hold a bearish bias on NZD/CAD over the medium term. An appropriate target level would be our PPP model’s fair value estimate (in 2019) at the 0.82 handle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.