From a high of 81 cents in January and back down to 77 cents this month, the AUD has had some sizeable swings this year. In this note, FX analyst Greg Gibbs looks at how a lot can be blamed on things happening outside of Australia
By Greg Gibbs, founder, analyst and PM at Amplifying Global FX Capital
What’s up (and down) with the Aussie dollar
The Aussie dollar was surging early this year, from a low in December near 75 cents to reach above 81 cents by the end of January; its highest level since 2015 (see Figure 1). Since January, it has been a pretty volatile beast with some sizeable swings, leaving investors battered, bruised and confused. As I write, the AUD has fallen back below 77 cents. On balance, I see more downside than upside risks, but trade location has become more crucial, and we should continue to expect swings without a clear trend.
Volatility in global markets spilling over to AUD
A lot is going on in the world and it is generating uncertainty in foreign exchange (FX) markets, with the AUD buffered mostly by factors outside of Australia. Trump continues to create a lot of drama, having slapped tariffs on steel and aluminium, and threatening to unleash trade wars; in particular, he has China in his cross hairs.
A surge in US bond yields helped triggered a sharp equity market correction in early February, and the equity market has remained more volatile since then; not helped by the trade protectionist rhetoric.
AUD buffeted by global equity market volatility
Figure 1
What are the chances Trump goes quietly?
The US political drama remains a factor that is buffeting FX markets. Two weeks ago, a Pennsylvania special election for a House of Representatives seat saw a 20 percent swing against the Republican Party candidate, handing the win to the Democrats. This is an ominous sign for Republicans in the November mid term elections.
You might say, so what? It wouldn’t be the first time the balance of power in Congress swung to the other side of the White House. But Trump is facing a genuine and significant threat of being impeached. If one, or worse, both Houses of Congress go to the Democrats, the risk of impeachment rises sharply.
Probability of controlling the House of Representatives
The probability after 2018 midterms moves further in favour of Democrats after the Pennsylvania special election based on Predictit.org (see Figure 2).
Source: Predictit.org
Figure 2
The Special Council investigation by Mueller appears to have Trump and his legal team running scared – to the point where Trump is desperately discrediting the process as a deep state conspiracy. The mud is being slung; fired FBI Director Comey releases a tell all book in mid April and goes on air to share his side of the story. Mueller is digging wide and far into the Trump business and other dealings with Russia actors.
The news just never stops with Trump. Some of it has been good – Congress passed big company tax cuts, expanded spending and pushed the debt ceiling off the agenda at least for another year. The US economy is booming and Trump is claiming credit.
However, both US voters and global investors are turned off by the chaotic brassy reality TV style of the Trump presidency. Arguably, the USD would be much stronger with a more normal White House. As it stands, no one is sure how long Trump will last and what kind of damage he may inflict on government process and geopolitics on his way out. No one expects him to go quietly.
Net approval rating for Trump
Some improvement on tax cuts and stronger economic performance this year, but overall Trump’s approval rating remains depressed, see Figure 3.
Sources: Real Clear Politics, Bloomberg
Figure 3
Widening AUD yield disadvantage
The political chaos has so far undermined the USD. However, the booming US economy, which is running up against capacity constraints, has pushed up US rates and yields, and widening the USD yield advantage against a wide swathe of currencies including the AUD.
Along with short term yields spreads, the 10 year nominal yield spread and real spread (based on government inflation-linked bonds) are negative for the AUD and at record lows
Figure 4
Combined with heightened geopolitical risks arising mostly from Trump’s trade protectionist policy direction, rising US yields has spilled over to more volatile global equity markets.
More volatile equities and higher US yields are tending to help support the USD in recent months, although it has been a mixed and messy recovery in the USD. The jury is out as to whether it will last.
Twin deficits enters the discussion for the dollar
Global market sentiment towards the USD has soured over the last year. The USD is much weaker than its interest rate and yield improvement suggests it should be. Investors are looking ahead to the end of quantitative easing (QE) in Europe and even Japan, and at the same time increasingly concerned by the widening fiscal and current account (twin) deficits in the US. Emerging market and commodity currencies are benefiting from a global economic recovery, boosting export growth.
USA twin deficits are a growing concern for the market. This may weaken the longer term outlook for the USD, but should it matter right now as US yields continue to rise?
Figure 5
However, the USD exchange rate has become so stretched from its yield advantage that it may now be resisting further depreciation. The US economy is punching out strong economic numbers and upward pressure remains on US yields.
It is premature to conclude that the US is approaching the end of its tightening cycle. Perhaps down the road, if the US economy begins to falter and peak US yields are in sight, then the market should fret deeply about the twin deficits. At this stage, this is nowhere on the horizon.
In saying this, I am not counting myself in the bear camp for the USD. The political turmoil certainly poses risks for the USD, but the turmoil has started to spill more into global asset markets, especially with the rising trade protectionist threat. As such, it is no longer so clearly a sell signal for the USD.
I think we can start to take more of our cue from US economic performance and the outlook for US rates and yields. The risks lie towards higher US yields as the fiscal expansion drives growth and boosts inflation expectations.
Australian rate hikes still not clearly in view
The case for policy tightening in Australia is still a bit too far off and uncertain to offer much support for the AUD. Business confidence is booming and employment growth is strong, and these are a plus for the AUD. However, investors still have to consider the risks arising from the Chinese economy and the Australian housing market and household debt.
US Cash rates now above Australian cash rates for the first time since 2000
Figure 6
Policy and housing market risks
By the time rate hikes come into view, the Australian political cycle will be more in focus. The opposition Labor Party has maintained a sustained two party preferred lead over the Liberal National Government for nine months. The Labor Party’s policies of removing negative gearing and halving the capital gain deduction on investment in established residential property is a threat to the housing market and may extend its recent downturn well into next year.
Credit conditions for mortgage borrowing have tightened over the last year due to regulatory pressure on banks. The Royal Commission into misconduct by banks and the wider financial services industry is likely to result in a further tightening in credit conditions, adding to downside risks for housing and potentially undermining consumer confidence.
An additional risk is the slowing pace of QE by major countries and fiscal expansion, and emerging global inflation pressure – these factors will place upward pressure on global bond yields. This may push up Australian banks’ funding costs as the year progresses. Even before the Reserve Bank (RBA) begins to raise rates, mortgage rates in Australia may begin to creep higher later this year or next year, which may further delay the need for the RBA to hike.
In any case, the Australian economy is likely to be significantly more sensitive to rising interest rates, due to the high level of household debt and the importance of the housing market in household wealth.
As such, AUD interest rate and yields may lag further below those in the USA for some time and well into next year.
The market has become particularly attuned to responding to even a whiff of rate hikes well in advance for currencies other than the USD. It is possible that a strong Australian economic recovery this year could bring forward rate hike expectations and provide a boost for the AUD at some stage. However, the broad outlook remains for a widening AUD yield disadvantage. As such, we are not betting on a sustained AUD rally for the foreseeable future.
China curveballs
Since the tariff news, iron ore prices in China have retreated. In recent weeks, the AUD has retreated with them. Tariffs on steel influence the AUD, since Australia is a major exporter of steel-making commodities. If the tariffs encourage faster consolidation of the Chinese steel sector, then this should reduce demand for Australian commodities.
If the US’ broader protectionist policies contribute to weaker global trade, this poses a threat to emerging markets and global growth. Both should work against the AUD (see Figure 7).
Chinese iron ore prices slip since tariff news
Figure 7
Chinese economic growth last year was stronger than expected and helped support the AUD. However, China appears to have accelerated reform in its financial system, tightening credit conditions. The Chinese property market is also weaker over recent months and this may further reduce its demand for steel.
While the RBA is more upbeat on global economic growth than it has been for years, the impetus for demand for Australian commodities is facing some risks and this may further dampen the AUD performance.
We need to weigh up the importance of all these factors, and how they may feed through to other asset classes and back to the AUD. From here, the roads are twisted with multiple forks that make it difficult to forecast with any confidence. For what it’s worth, current market psychology based on its trading pattern over the last three years, places the AUD/USD in a 0.75/0.80 range.
In short, we see downside risks for the AUD and would prefer to trade from the short side in this range.