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Dairy Payouts - Why the Big Swings?

Economics for you

Your questions to economist Anthony Byett

This month: Dairy payouts

Kevin asks, "My clients include a number of dairy farmers. They are a little shell-shocked at present with the massive swings in Fonterra’s payout. Can you offer any insights into what payout figure to use for budgeting over the next couple of seasons?”

In early 2008 dairy prices had reached a new plateau, or so it seemed at the time. Export dairy prices increased more than 100% over 2007 and 2008; demand was strong and global supplies were tight. Today prices are back around the levels of 2005 and 2006, still higher than in earlier years but half the levels of this time last year. Consequently the dairy payout has gone from $7.66 per kilogram last season to hopefully $5.10 this season, albeit with a longer delay for the last 22.5c. Next season the payout will probably drop slightly further again.

If nothing else the lesson of the last 2-3 years is that international dairy prices cannot be forecast accurately. That should not be surprising given that dairy exports – only 8% of global production – include the residual of domestic supply. Nonetheless farmers and accountants have to have some income level in mind when budgeting and planning. There are five factors that offer some hope for future years but suggest tight budgets for the next year or two.

1) Dairy product prices on global markets have stopped falling.

2) Fonterra – the world’s largest exporter – has committed its stock for 2008/09 season.

3) Other commodity markets are factoring in higher prices in the next 1-2 years. Commodity markets are not as closely correlated as often thought but the fact that the likes of oil and copper are priced higher for future delivery implies some powerful economic players are working on the assumption that global demand in general will increase soon. The guarded optimism comes from two aspects: there is an expectation that the huge growth momentum in the likes of Brazil, Russia, India, Indonesia, China and South Africa – the BRIICS – has only been checked, not stopped; and second there is the niggling fear that the massive global government stimuli being put in place at present will create an inflation wave.

Now the dampening factors.

4) Fonterra is likely to have hedged a large proportion of anticipated income for the 2009/10 season, hopefully below the 63c average of the past 12 months. While possibly not viewed as a positive factor at present, this may prove useful should the NZD/USD rally strongly.

5) The big risk revolves around the coming European season. Government has reintroduced a 3-6 month purchase arrangement that sees surplus stocks dumped on global markets. European production is not expected to increase this season but, then again, demand could well prove slow, leading to continued excess supplies on global markets.

More generally, a key risk is that global growth does not pick up as expected. The magnitude of the global financial shock was huge. It is safe to assume that government authorities have not correctly matched the policy response to the shock; over- or under-steering is inevitable. Under-steer and we will not see any general commodity price increase in the next 12 months. Fortunately the greater risk appears to be over-steering but even that presents problems as there will be a sharp monetary and fiscal tightening response, and probably another brief recession a year or two down the track.

In sum, history, emerging economy momentum and the current action of authorities suggest international dairy prices will trend higher in the next 5-10 years but the past 10-year average payout of $4.80/kg is probably a prudent starting point for the next year or two.

Anthony Byett

April 2009

Your chance to answer that niggling economic or finance question, for free …

Anthony Byett, former Chief Economist at ASB, has happily agreed to make himself available for readers' questions, providing his answers through Phoenix's monthly newsletter. Feel free to tap into Anthony's extensive knowledge and links within economics and finance by sending your query to anthony.byett@fxmatters.co.nz or to your local Phoenix Recruitment consultant.

Interest rates: How long should I fix for?

Market Matters - Moving bank rates

Shopping by price should be easy, you would think. In the case of debt, borrowers should look for the lowest rate and investors the highest – right? If only it were that easy.

At the time of writing you could borrow from one of the major banks at between 5.8% p.a. for 12 months and 6.5% p.a. for 5 years. You could invest with one of the major banks at between 4.1% p.a. for 4 months and 6.0% p.a. for 5 years. The temptation for borrowers is to take the short-term rate and for depositors to take the long-term rate. The problem is that the short-term rate in 4 or 12 months may be higher than its current level.

This is not the most likely scenario according to the Reserve Bank of New Zealand, but they do warn we are near the bottom of the interest rate cycle. Their projections are for short-term interest rates to start rising in about 12 months, jumping around 1% each year over the following two years. At a glance, this shows the currently higher 5-year rates in a more favourable light to borrowers, and as less favourable to investors.

However, the RBNZ are not always right. Furthermore, long-term interest rates can move differently to short-term rates. There is no easy answer to which term is best but the following factors may aid decision making.

First, some historical perspective on fixed interest rates. The interest rates available at banks typically move in accord with government interest rates, give or take a variable margin. It is these government rates that are easier to compare globally, and over time. At present the going rate for the NZ government to borrow money for 5 years at a fixed rate is 4% p.a. This is low compared to the 6% p.a. average of the previous ten years but such a rate looks positively generous when considered against the 2% p.a. now paid by the governments of the US, UK and Germany for new 5-year debt. Historically long-term yields at these levels do not continue. Over centuries long-term government bond yields in Europe and the US have tended to be above 3% p.a. True, very low rates have persisted in Japan in recent years, and long-term rates did remain low in the US during the 1930s (average 2.4%) but such times appear as exceptions rather than the norm.

The question, then, is today another exception? In truth, we cannot be sure yet. But we do know that central banks around the world are going to extreme lengths to avert another global depression, and that governments are running up debt quickly. This mix hints at higher global long-term rates to come over the next few years. And if that proves to be the case, then NZ long-term rates will rise also.

We do also know that interest rates can move by 2-3% or more within 12 months when economies move out of recessions. And that long-term interest rates are likely to move upward before short-term rates.

The issue for borrowers and investors alike is one of timing versus risk. With global growth still low and numerous event risks still high then working on the basis of low interest rates throughout 2009 is reasonable. That implies that investors look for terms near 12-24 months with the best yield, and for borrowers to favour a Variable or 6-month term; investors to position for a series of higher-yielding short-term deposits in the next few years, and borrowers to position for a lower 5-year rate to possibly emerge soon. More risk-averse people would look at the situation differently, longer terms being more suited to investors and borrowers alike.

Anthony Byett

fxmatters.co.nz

March 2009

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