KEY POINTS:
Borrowing cheap Japanese money to earn the positive "carry" of a high-yielding currency like the New Zealand dollar has given investors a 41 per cent return in the past year.
It has also pushed the kiwi higher by 13 per cent against the US dollar this year making it reach levels that Reserve Bank Governor Alan Bollard has said are "not sustainable medium term".
Yet soaring milk prices and the avalanche of money that is betting on cheap yen are key reasons why the Governor may not be able to tame the surge in the kiwi for long.
Let's first consider milk.
Dairy demand seems to be exploding in China and Latin America. Milk futures have climbed 60 per cent this year on the Chicago Mercantile Exchange.
Milk and milk products account for a fifth of New Zealand's exports and the high prices are boosting the country's terms of trade.
What does this additional income for New Zealand's farmers mean for the currency?
Bollard said last month: "To the extent that some of it is spent, it may make it harder to achieve our medium-term inflation target."
"This effect could be compounded even further if these higher incomes become reflected in higher rural land prices."
Any acceleration in land prices will feed into domestic demand through a wealth effect, he added.
All of this suggests that interest rates in New Zealand have perhaps not peaked yet, especially when the job market is tight and house prices and credit-card spending are buoyant.
On Thursday, while raising the official cash rate by a quarter point to 8.25 per cent, Bollard said: "New Zealanders have been showing early signs of moderating their borrowing.
"Provided they keep this up, and the pressure on resources continues to ease, we think the four successive OCR increases we have delivered will be sufficient to contain inflation."
The market ignored the caveats in that message and took Bollard's remarks as a definitive sign that the carry trade would unwind.
Is this the beginning of a sustained sell-off in the kiwi?
Perhaps not. UK floods may depress dairy production in Europe's third-biggest milk-producing nation, prompting prices to move higher.
Bollard himself is bullish on milk prices. "It is certainly possible that we could be heading into a 'new era' for dairy prices."
Dairy exports are playing a role in the currency's appreciation, and a strong kiwi is exacerbating the lack of pricing power confronting sheep and beef farmers. But their fortunes may also now be turning. The slide in cattle prices that began in April ended last month, Chicago futures prices show.
More New Zealand farmers may end up with larger incomes.
In such a scenario, it's doubtful if the country can escape the riches that currency traders are going to shower upon it. And, of course, a large chunk of that money is almost free, because it's all borrowed in yen.
Traders see a two-thirds probability that the Bank of Japan will raise its overnight lending rate by a quarter percentage point to 0.75 per cent at its August policy meeting.
However, it's far from certain that those expectations won't be curtailed in the days ahead. The median forecast for Japan's policy rate at the end of June 2008 is for 1 per cent, says a survey.
Meanwhile, after Thursday's increase, most analysts are now convinced that Bollard will keep the policy rate unchanged until the middle of next year.
That means the yield difference between New Zealand and Japan will compress, though not by much.
For the carry trade to unwind, the yield differential between New Zealand and Japan has to narrow significantly, or the trade has to become too volatile to be worth the risk.
Michael Metcalfe, head of macro strategy at State Street Global Markets in London, says: "Historically, volatility is still low. For the moment, the appetite for risk of institutional investors is still intact."
The kiwi may not be off the hook just yet.
- Andy Mukherjee is a Bloomberg News columnist.
