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Milk got your carry trade?

Leslie Shaffer | Writer for
Dairy cows at a farm operated by Synlait Milk in the town of Rakaia, around 60km from Christchurch, New Zealand
Brendon O'Hagan | Bloomberg | Getty Images

The price of milk may start to unravel the popular carry trade of using low-yielding currencies such as the yen or U.S. dollar to buy higher-yielding New Zealand dollar assets.

ANZ advises selling the New Zealand dollar, also known as the kiwi, on any rallies, largely on the declining dairy prices.

Two of the last three GlobalDairyTrade auctions showed "very poor results," with dairy prices racking up a year-to-date 28 percent decline, Sam Tuck, a foreign-exchange strategist at ANZ, said in a note Tuesday.

Read More Are carry trades getting risky?

The bank cut its 2014-15 milk price forecast to around 6 New Zealand dollars ($5.25) per kilogram of milk solid from around 7 New Zealand dollars.

RBNZ seems happy with Kiwi dollar: Westpac

"This change removes nearly 3 billion New Zealand dollars in income from farmers compared to 2013-14, which equates to 1.3 percent of gross domestic product," Tuck said. Lower farm profitability "quickly starts to eat into discretionary spending."

A slower domestic economy coupled with the declining value of a key export may put the kibosh on expectations the Reserve Bank of New Zealand (RBNZ) will continue to raise interest rates, which would have supported the kiwi.

A key component of a carry trade is for the asset purchased, in this case the New Zealand dollar, to appreciate against the funding currency.

Read More Yen at 110 in 2014? Don't count on it, says Mr Yen

"The RBNZ remains very concerned about the strong New Zealand dollar, particularly in the context of recent commodity price declines," Hamish Pepper, a foreign-exchange strategist at Barclays, said in a note last week. Dairy makes up around 30 percent of the country's total merchandise exports and New Zealand commodity prices in general are down around 10 percent year-to-date, he noted.

Pepper expects the risk is rising that the RBNZ may disappoint the market's hopes for more than 50 basis points worth of rate hikes by year end.

Read More Are the dollar's carry trade days numbered?

So far, the New Zealand dollar remains buoyant, up around 6.7 percent against the U.S. dollar so far this year, touching its highest levels since the middle of 2011. Net CFTC long contracts in the New Zealand dollar rose to 5,900 last week, from 3,200 the previous week, according to data from ANZ.

Lactophobia isn't the only risk to the kiwi: The New Zealand dollar carry trade is a "tad crowded" as investors seek higher yields, Mizuho said in a note Monday.

In June, the RBNZ raised rates to 3.25 percent, compared with policy rates of effectively zero in most other developed markets, including Japan, the U.S. and the EU.

Expect RBNZ to remain hawish: Economist

"There is an outside risk of sharp correction if risk appetite sours," Mizuho said.

Another possible headwind may come from a potential slowdown of fund flows from Japan.

While New Zealand has seen a resurgence of interest from Japanese bond investors, "these flows are unlikely to be sustained given they are at the expense of other markets rather than reflecting a broader pick-up in flows from Japan," Richard Yetsenga, head of global markets research at ANZ, said in a note last month.

Read More Commentary: What history tells us about the carry trade: El-Erian

He noted that while issuance of New Zealand dollar-denominated Uridashi, or bonds denominated in foreign currencies and sold to Japanese household investors, appears to have doubled from last year, it's likely to come in around $1.5 billion this year, well below the $4 billion-$6 billion levels in 2007-10.

Similarly, New Zealand dollar holdings of "toushin" funds, or mutual funds, are only up around $10 million from their lows, signaling only stabilization after sharp decline in flows over 2011-13, he said.

ANZ expects the kiwi will only fetch $0.83 by year end, compared with the current around $0.8760.

Read More It may be four rate hikes in a row for New Zealand

To be sure, some expect the kiwi carry trade will continue to perform.

"While the expected drop in dairy prices could put some pressure on the New Zealand dollar, export prices should remain elevated in general," Gary Yau, an analyst at Credit Agricole, said in a mid-year strategy update this week.

"Further rate hikes by the central bank and strong growth momentum should offset any negative impacts," he said. Despite subdued inflation and a soft labor market, he expects the RBNZ's tightening cycle won't be interrupted amid signs of pressure on capacity.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter