Tuesday 21 April 2015 by Craig Swanger Opinion

Update on the US dollar

"We see the $A at 72c by December”, Bill Evans, Chief Economist at Westpac.

“The combination of a slowing China, weak domestic economy, rich valuations, a stalling domestic economic transition and an RBA with an easing bias will drive the Aussie dollar to 65 cents”, Morgan Stanley.

“Policy divergence is directionally unchanged…we remain bearish on the AUD to 71.85c”, Credit Suisse.

“We remain short the Australian dollar and long the U.S. dollar.  We still expect the macro environment to remain tough in Asia”, PIMCO.

“We now forecast AUD/USD will trade at 0.7000 at the end of 2015”, CBA.

“We expect the AUD to trade between 70c and 75c, with bad news out of China applying plenty of downward pressure”, Citi.

Summary
Since our original call on the AUD/USD exchange rate in August 2014, a lot has changed:

  • The AUD has fallen in stages from 94c to 75c, then bounced between 75c and 79c for the past few weeks
  • The RBA has announced a specific policy of targeting fair value for the AUD (in their eyes this is 75c)
  • Markets have adjusted to the “lower for longer” trend, lowering US 10 year rates to below 1.9%p.a.
  • The US Fed has thrown markets into a period of volatility by delaying the first interest rate hike

So the obvious questions are “Do we still have the same view of the AUD/USD market?” and “What strategies are best from here?”  In short, yes we still have the same view of the AUD/USD rate – we believe the exchange rate will continue on its path toward 70c and beyond; and we still believe that that path will get more volatile the lower it goes.   

As for strategy, as we cover in this note, for those with the stomach for currency volatility, there is still some way to go on the long USD strategy, so for those in USD positions, hold; and for those looking to increase their exposure, look for opportunities above 77c to add positions. That’s the upside of the current volatility; there is plenty of opportunity to time your market entry. 

But for those that started with USD corporate bond positions early and with a lower appetite for volatility, there will soon come a time that it makes sense to take some profits off the table, maybe considering another currency such as the GBP. 

Background on FIIG’s research on the USD

In August 2014, when the AUD was 94c against the USD, all the major economists in Australia were calling for small falls in the AUD/USD exchange rate to 85-90c. We published our view at the time that 75c was more likely. That view was based on a highly likely bull run for the USD and the historic weakness of the AUD when the global economy is weak relative to the US economy.   

In our 2015 Smart Income Report published earlier this year, when the AUD/USD was at 82c, we reiterated our view on a lower AUD, and said that a rate below 70c was on the cards but that volatility would pick up below 75c, creating buying opportunities but also increasing risk (see pages 14 and 15 of the Report).   

Since then the AUD has continued to fall, reaching 75-76c range on a few occasions, but then recovering to 78c before retreating again. Most banks are now forecasting further falls, as quoted above. Throughout this volatility, we’ve been asked if we still hold our view that a 65-70c range is possible. There is certainly plenty of news at the moment to create a lot of volatility in the exchange rate, which is an important consideration in itself.   

So in answer to this question: yes we do still hold this view. The bottom line is:

  1. Yes, we still hold our view of 65-70c as being the most probable end of this cycle.
  2. That we also still hold our view that the closer we get to that value, the more that volatility will rise.
  3. We also still hold our view that markets are overestimated just how low and how long the “lower for longer” theme will run.

That’s not to say that a lower AUD/USD rate is a sure thing. There are two factors that could prevent this from happening:

  1. The US economy weakens further.
  2. The RBA stops targeting a lower exchange rate. 

In this update therefore, we look at the changes to global economics, markets and central bank policy that might impact new risks and opportunities. The purpose of this is help investors consider whether they hold, buy or sell foreign currency corporate bonds in particular.

US Economy and Federal Reserve updates

At the start of the year, US markets were pricing in three to four interest rate increases by the Fed in 2015. This wasn’t consistent with our lower for longer view, but was consistent with Wall Street’s 12 year track record of overestimating interest rate increases in any given year. This year appears no different. Ten year Treasuries in the US are already trading 50basis points lower than in January and now market consensus is for one to two rate increases only.

Markets are now pricing long term rates nearing their fair values in our view. There is some chance of further downwards revision in yields, based on fundamentals (see Robert Shiller, Nobel Prize winner, believes US rates have further to fall for an example), but the market is finally pricing in the reality of a long period of low interest rates ahead. 

The main driver of this view is global economics.The EU economy has a long road to recovery. Headlines at present point to improving conditions, but that is compliments of the massive QE capital injection. QE cannot be sustained forever. China is slowing, as expected and Japan is yet to respond meaningfully even with its QE program. The US and UK remain the only bright spots in the developed world (more on the UK and the implications for the GBP and UK corporates in coming editions of The WIRE). 

We expect a long term economic growth rate that is below historic growth rates, but above current levels. The US economy is likely to have a very poor 1Q15 GDP measure of around 0.3% (to be announced 29 April 2015) due to the triple impact of lower oil prices impacting oil investment projects; a severe winter in the North-East; and the knock-on impact of the higher USD on exports. But the full year GDP will still be around 2.25%.   

This rate of growth, with the considerable risk of further shocks to recovery as rates rise, means that there is little chance of the Fed increasing rates any faster than absolutely necessary. The key measures for the Fed will be inflation and unemployment. The role of central banks is to keep as many people employed as possible, without having inflation pushed up beyond their target rate. 

When an economy is nearly its maximum capacity, trying to reduce unemployment further will put upward pressure on wages, which in turn will increase inflation. For this reason, once an economy starts to approach maximum capacity, the central bank will increase rates to try to slow the economy down and avoid inflation rising too high. 

US Unemployment rate vs 'U-6' rate graph
At present, inflation is running well below the Fed’s target of 2% p.a., meaning they are unlikely to be forced to raise rates any time soon. Unemployment is the most important measure, but while headline unemployment is low at 5.5%, this isn’t the only measure the Fed will examine. They will also closely monitor how many people have given up looking for work and therefore not measured in the headline rate. 

The Fed will be watching a measure known as “U-6”, as opposed to the “U-3” headline measure of unemployment.
U-6 measures how many people are unemployed and those that have left the workforce (given up) or those underemployed (part time when they want to be full time). As shown adjacent, U-6 is currently 10.9%, down from 17.1% in 2009 but still very high. 

The gap between the U-6 rate is a reflection of the long term capacity of the economy not captured by the headline rate.  It is currently 5.5% (that is the U-6 rate of 10.9% is 5.5% higher than the headline unemployment rate of 5.4%). The long term average “gap” is 3.8%.

This measure could imply that US rates could stay at current levels until 2016. 

Australian economy and RBA updates

The Australian economy is following our expected path in 2015; shaky, but maintaining positive growth albeit below long term averages. Housing construction is at all-time highs, and business conditions are holding up. These factors are making up for the dramatic decline in mining projects, and weak consumer confidence. Unemployment data suggests an improvement, although the data has lacked credibility lately, so we’d like to see three to four months of improving results to support this.   

All-in-all, Australia’s economy is holding up despite the mining investment slump. This would ordinarily leave the RBA with a neutral policy, that is, they would leave rates unchanged. However all of that changed earlier this year when the RBA officially stated that it would be setting monetary policy to drive the AUD down to its “fair value”, defined at the time as 75c.   

With this target price in mind, and with Sydney house prices finally slowing their climb, the RBA is expected to lower rates at least one more time. Some economists still believe they will lower rates beyond this and go as low as 1.75% or even 1.50%.  The only scenario likely to drive rates that low is a real risk of an Australian recession, or a jump in the AUD/USD exchange rate. 

Lower for longer in the US combined with RBA currency targeting creates hedge

The RBA’s policy of driving the AUD/USD rate down using interest rates creates an interesting hedge for investors. In the event that the exchange rate proves stubborn and remains above 75c, the RBA is very likely to lower rates further until the exchange rate does fall. For investors in USD denominated corporate bonds therefore, they have the RBA providing something of a hedge, supporting their returns even if markets don’t push the USD higher by themselves. 

Final word - Volatility

Volatility is higher in all markets in 2015, with currency markets being no exception. The AUD/USD exchange rate has been very volatile lately and once the decline resumes below 75c, volatility will get even higher. Bond investors are usually seeking lower volatility so for some, this might be signal to cash in on capital gains already made. For others looking at the longer term position, chances are that there is another 10-15% left in the AUD/USD rate decline, so they could use the volatility to buy in above 77c.

Conclusion

In our 2015 Smart Income Report, we said we expected the AUD/USD exchange to continue to fall to 75c, with a 65-70c range on the cards; that volatility would remain high in 2015; and finally that the US economy would be the shining light globally, albeit at lower than long term averages. None of these expectations have changed. The key change so far in 2015 is the RBA’s specific targeting of a lower AUD/USD exchange rate. This change supports taking a longer term view of the USD rising against the AUD, and increases the likelihood of a rate lower than 75c becoming the norm in the coming years.