FX market has not priced risks of Chinese slowdown into AUD
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Foreign Exchange

FX market has not priced risks of Chinese slowdown into AUD

The risk premium of slower Chinese growth might not be sufficiently priced into the Australian dollar, despite a recent decline in the exchange rate, according to JPMorgan.

The performance of mining stocks and commodity prices point to a weaker Aussie.

In the past two weeks, Chinese data – notably Markit PMI and monthly trade figures – have undershot expectations, and the Australian economy, with more than a quarter of all its exports going to China, is particularly vulnerable to any downturn in the world’s second largest economy.

After the weaker-than-expected data, markets – including the Australian dollar exchange rate – have corrected lower but the move in the currency might not be enough to justify the risks posed to the economy, says Paul Meggyesi, FX strategist at JPMorgan.

“The recent decline in the exchange rate has merely removed [the Australian dollar’s] high-frequency overvaluation, but there is as yet no undervaluation to compensate investors for the risks around China,” says Meggyesi.

JPMorgan says that while a Chinese “hard-landing” is not their base case, uncertainty surrounding the Chinese outlook is likely to persist for a number of months. Against this backdrop, an increase in this risk premium in AUD is justified to reflect this.

Meggyesi says one way to gauge the downside risk to AUD is to compare it with its closest medium-term correlate – Australian mining stocks, with which the trade-weighted AUD exchange shares a 90% correlation since 2007.

China slowdown fears are weighing more heavily
on Australian mining stocks than AUD 

 Source: JPMorgan

The move lower in stocks, compared with the currency, suggests equity markets are taking the risks from China more seriously than the FX market. This comparison suggests that even allowing for the recent slippage in AUD, the currency is still 10% more expensive versus mining stocks. Further comparisons with commodity price indexes imply that terms of trade support for AUD might also be fading, with Reserve Bank of Australia commodity prices continuing to stagnate, as they have during the past year.

Terms of trade support from commodity prices
for AUD may be fading

Source: JPMorgan

To reflect the view of future weakness in the Australian dollar, JPMorgan recommends buying a two-month 1.00 AUD put/USD call, while staying short a two-month AUD call/USD put with a reverse knock in.

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