In a volatile few weeks, the AUD/USD rate broke through 80 cents for the first time since December 2014. The reasons for this are a fall in the USD against most currencies and rising expectations around the Australian economy’s outlook. Here we give our currency outlook given these perceptions
After oscillating between 73 cents and 77 cents for the past six months, the AUD/USD rate broke out of that range and through 80 cents, albeit briefly and is now back between 79 and 80 cents.
The reason for this large and sudden move is two compounding views held by global traders:
1. Falling confidence in the Trump administration pushing down the USD against most currencies.
2. Rising confidence in the outlook for the Australian economy given RBA commentary.
Currency markets are different to any other market in that there is always a “winner” and a “loser”. There is no such thing as the price of the Australian dollar for example; instead there is a price relative to another currency. This means that the price of the AUD in USD (“AUD/USD” for short) can rise due to either a rise in the AUD or a fall in the USD. It can even rise despite the AUD falling against other currencies, if the USD’s average fall is greater than the AUD’s average rise.
Figure 1 shows the AUD/USD over the past five years to illustrate the different reasons for some of the large moves in that time:
- From mid-2012 the AUD/USD fell while the USD against most currencies was flat, showing the cause to be a falling AUD. In that time, the AUD/USD fell from its $1.02-$1.07 range to a $0.90-$0.95 range.
- Then from mid-2014, the USD started to strengthen due to clear signs that the US economy was recovering strongly and ahead of the rest of the world. In the next year, the USD rose 26% from an index level of 75 to 95. The AUD/USD didn’t respond at first (meaning it must have risen against other currencies, keeping pace with the USD’s rise), but then the AUD/USD fell sharply first to around 80 cents then to a 69-75 cents range.
- In 2016, volatility in Europe due to Brexit and then optimism about the inflationary stimulus likely from the Trump administration caused the EUR and GBP to fall, pushing up the AUD and USD together and creating little change in the AUD/USD level.
- Then, the most recent two months has been due to both a falling USD and a rising AUD. The USD has fallen 4.2% in the past month against the trade weighted basket of other currencies. So far in 2017, that fall is 7.6%. While the basket is very heavily weighted toward the Euro (57%), the fall has been across most currencies as the shine has slowly come off the Trump administration’s ability to execute its fiscal stimulus and tax policy initiatives.
Rise in the AUD in 2017
In 2017, the AUD has risen against most currencies, largely because the
expectations of further rate cuts evaporated and been replaced by expectations of rate increases. The AUD is up 5.6% against the USD in the past month and 10.2% in 2017 so far.
This suggests that the change in the AUD/USD rate, which is mostly about the USD, is also at least partly about a rising AUD. This has been particularly true over the past two months, as shown in Figure 2, where there have been two clear “breakaway” periods for the AUD/USD rate outpacing the fall in the USD Basket Index.
The most sudden of these jumps came off the back of the RBA’s bullish commentary about labour markets and then its announcement that the neutral rate was 3.5%pa, which markets understandably took to mean that the RBA was planning to move rates back to those levels. Both the Governor and Deputy Governor quickly retreated from those implications in the 48 hours following, but the damage had been done and the AUD held its ground.
Speculative trading in AUD/USD
Speculative traders are non commercial traders; in other words buyers or sellers of AUD/USD for the purposes of trading, not to hedge a commercial position relating to some real economy trade such as export/import or foreign investment. These are typically hedge funds. Traders can be “long” (betting on a rising AUD/USD rate) or “short” (betting on a falling AUD/USD rate), and we refer to their “net position” being longs minus shorts. Speculative traders have sharply increased their net positions in AUD/USD over the past eight weeks. Until the RBA’s comments, this was mostly about the speculators wanting to be short USD as evidenced by similar long positions in EUR/USD and GBP/USD. But, in the past two weeks, the long positions in AUD have strengthened further which has shown specific support for the AUD.
Speculative traders have around a 50/50 track record on the AUD/USD but they have missed the largest moves including the 2012/13 and 2014 steep drops in the AUD/USD rate. As a purely long term currency investor, that is as someone that doesn’t believe in the sanity of trading currency day to day, I tend to ignore speculative traders moves other than to understand when market moves are driven by them or by more fundamental issues.
Outlook for the AUD/USD
So what does the above mean for the exchange rate outlook?
Firstly, on the USD front, the sell off appears overdone. The jump in the USD on Trump’s victory was definitely an overreaction in hindsight and that jump has now been wiped out. The USD Basket Index was around 90-92 in the post-Brexit months prior to the election and 90-95 in the year before that. This was the market’s assessment of the USD’s value once the economy showed strong signs of recovery but before the “Trump bump”. The economy is still on the same trajectory it was then; inflation is slightly weaker but employment continues to strengthen.
So, in the absence of any other information, 90-92 would seem to be a logical and fair value in the near term. It is currently at 87-88. This would put the USD around 2-4% oversold. Arguably, it is at the lower end of that range because the Fed’s expected path is slowing, but the unwinding of the Fed’ balance sheet from their Quantitative Easing buying of USD bonds will likely steepen the curve enough to offset this slowing.
On the AUD front, the buying pressure that has stemmed from the RBA’s optimistic commentary, and as I’ve opined before, the selective use of economic indicators, would suggest it could have been overbought. Add to that the evidence of the sudden rise in speculative buying, and that view gets stronger. The Australian economy is showing no more strength now than it has at the same time in 2015 and 2016 before slowing again later in the calendar year. I see no real evidence to believe we won’t see the same pattern this year, particularly with the pending slowdown in construction. If the government can bring on faster infrastructure spending - that would certainly help - but a challenging political situation doesn’t bode well on that front.
Longer term outlook
Little has changed on my view of the AUD/USD. Depending upon who you ask at FIIG, our belief is that the AUD/USD should be somewhere in the 65-75 cent range and I remain at 65-70 cents. More specifically, I believe fair value is at the 70 cent end if infrastructure spend can kick in before the end of the construction cycle in 2018 and at the 65 cent end of the range if China starts to crack under the pressure of the debt of its state owned enterprises.
Currency markets and interest rates are very closely linked. In my opinion, the recent expectation that the RBA will increase rates next was the direct result of markets buying into the RBA’s optimistic commentary. The facts, however, won’t support the RBA’s position. Markets will settle into an expectation that the RBA will hold rates and let the US and EU central banks lift rates to push down our currency and create the stimulus that the Australian economy needs, without the RBA having to take the risk of fuelling housing prices further.
US cash rates are now 25-50bps below Australia’s. Within the next 12 months, US cash rates will pass Australia’s in my view. The last time our short term yields were lower than the US was the Asian Currency Crisis of 1998, for just a few weeks, and prior to that in 1983. That outlook is my base case expectation with the only qualification being that the RBA will increase rates if the AUD falls and boosts the economy. Either way, the outlook for the AUD/USD is at least a shift back down toward 75 cents and more likely toward 70 cents.