John Hardy, consulting FX strategist with Saxo Bank: When is it time for AUDUSD to crash?
The trajectory of the Australian dollar is very much on the FX market’s mind of late, writes John J. Hardy, consulting FX strategist at Saxo Bank. Within the major currencies AUD seems to serve as a kind of handy universal proxy for global risk appetite – an instrument that you can buy on hope and sell on fear. Since the recovery from the early 2009 nadir in global market sentiment, the Australian dollar has rallied versus most world currencies, with mostly minor setbacks, save perhaps for the one significant adjustment during the crazy global equity market correction early this summer.
But now, once again, the Aussie is riding high, particularly against the US dollar – which is so often the flipside of the coin for risk traders. The US, after all, offers nothing in the way of yield, while the world watches nervously to see if the US Fed is about to launch another round of quantitative easing in its fight against a double dip in the economy and deflation – that will drive yields even lower and possibly devalue the US currency. But Australia has its own under-appreciated risks that, once realized by an overly complacent market, could mean a significant downward correction in the market’s assessment of Australia and its currency. Since the Aussie and the Greenback seem to be the yin and the yang of major currencies, the most dramatic correction in the Australia dollar could be versus its US counterpart. The following are just two of the interlocking reasons why the AUDUSD could face a severe correction lower sometime in the coming 12 months.
Taking the carry out of the AUDUSD carry trade
The Fed is keeping the interest rate at 0% and the market now expects that policy rate to continue indefinitely. Australia’s RBA, on the other hand, has taken rates from their 3.00% low during the crisis to a comparatively fat 4.50%. To the market’s assumption that the RBA is finished hiking for the foreseeable future we add our assumption that market expectations continue to move south and begin to price in a –200 basis points or more of easing from the central bank. This would put the interest rate differential at the short end of the curve at closer to 200bps rather than the current 400bps (using the two-year rate spread as an example. The last time the rate spread was at 200bps, AUDUSD was trading around 0.70 rather than 0.90. The chart below shows how important the interest rate differential is in determining the AUDUSD level.
And what will cause the RBA to have to lower rates? How about a housing bubble that is worse than the US bubble ever was, one that is showing signs of peaking out. Evidence for an imminent unwind in the Aussie housing bubble includes a sharp recent decline in building approvals, lower activity in the market despite record high price levels, and a sharply higher percentage of purchases going to speculators rather than occupants. As well, most new mortgages in Australia are done at adjustable rates. This meant that when the RBA slashed rates from 8% to 3% during the global financial crisis, housing prices quickly stabilized after a very modest drop and then rocketed higher in an after-boom stimulated by the sharply lower rates. But now, the RBA has been removing accommodation for almost a year and time is running out on this bubble.
Here we use the spread between the Australian and US two-year rates, since this allows for some measure of pricing in the central bank’s forward monetary policy expectations. Note how closely AUDUSD has tracked this differential, though it doesn’t explain everything. The large dip in the May/June time frame had a lot to do with the Australian government increasing taxation on the mining industry among others.
Exposure to China
It might be fair to say that Australia is simply a satellite economy of China, since so much of Australia’s natural resources head to the mainland to feed that country’s economy. But is China’s 10%-growth-for-ever policy still feasible? There are signs that China’s stimulus-led growth since the crisis is not proving the sustainable elixir the regime had hoped. Our proxy for Australia’s exposure to China is the mining giant BHP Billiton, far and away Australia’s largest mining company and a general proxy of the exports that are so crucial to the country’s economic strength. This is a better instrument for understanding expectations for China.
The relationship between the AUDUSD and BHP Billiton stock is particularly interesting because in some instances, BHP Billiton has been a leading indicator on the subsequent moves in AUDUSD – so the divergent weakness in the company's stock recently is a potential red flag. Of course, some of the BHP weakness has come from its clear intent to buy up assets elsewhere, which could mean a dilution of equity and capital (one can argue that this in itself can be AUD-negative at times because of the capital flow implications.)
The charts above hopefully give the reader something to chew on. The only likely triggers for a truly ugly sell-off in the AUDUSD (our eventual expectation) will come from the market lowering its expectations, which in turn will only come about once the Aussie housing bubble shows clearer signs of unwinding and/or when China experiences a hiccup after its massive stimulus efforts fail to spark sustainable growth and the country slows its imports of key commodities (and/or the price for those commodities drops). There are already signs of egregious overcapacity in the steel industry in China, to take one example, and Australia is a significant exporter of coal for steel-making and iron ore as well.
Of course, timing is often more difficult than being right. For example, Greenspan saw endless abuse from economists and market commentators back in 2003 and 2004 about how too-low rates could risk fuelling temporary asset bubbles – particularly in housing, rather than real, solid growth – and that we were just kicking structural problems down the road. These critics were very right, but when they were their most right some years later, no one believed the bubble would end, or if it even existed. So it is in our bearish AUD view; our confidence about the eventual scenario must be tempered with a respect for where the market can take us in the interim.
Important inputs that could alter or significantly delay our weak AUD scenario include a US Fed that goes all out with a QE2 program more quickly than we expect (we suspect the Fed will want to move again fairly soon, but may feel constrained by the political environment, which risks becoming more anti-Fed after the Tea Party led Republicans make significant gains at the mid-term election on November 2, not to mention increasing signs of division within the Fed). Another input that could significantly delay a large-scale setback for the Aussie is a renewed Chinese stimulus program that concentrates once again on infrastructure and other heavy projects that inevitably mean more exports for Australia and a Chinese version of extend and pretend. Of course, if China manages to pull off another reality-defying round of stimulus, AUD can continue to defy reality as well. The longer this goes on and the more China turns its economy into a wasteful ogre through gross distortions and investments from the public sector, the uglier the adjustment will be once it arrives.