Tuesday 07 June 2016 by Opinion

Finding opportunities in volatile currency markets

There is a not quite perfect but well developed storm brewing in currency markets, and history tells us that the AUD will get caught in the middle once again

For those looking for an opportunity to set a long term position or remove such a position, these periods of volatility can create opportunity.  For those already set, the most important thing is understanding what is causing the volatility and to stick to your plan. 

Key dates and drivers of upcoming volatility will likely include:

1. Brexit

The GBP is now one of the most volatile currencies in the developed world, with volatility at its highest point since February 2009 when the UK economy looked to be down and out post GFC.  Whether they leave or not is unlikely to have significant long term impacts on the UK economy.  The oft-cited risk on exit is a fall in trade due to a weaker relationship with Europe.  The simple fact is that the EU has free trade agreements with several non EU countries including Switzerland, Norway and even Canada.  It is unlikely that the EU would risk damaging its economy from less trade at a time when it cannot afford any new threats to its stability. 

On the other hand, the worst thing that could have happened for the UK economy is the vote itself, and the uncertainty that it has created.  Investment and hiring decisions have been deferred, having a real impact on the economy.  So the best thing that can happen for the UK is just to get past the referendum, set for 23 June, and allow certainty to return to the economy one way or the other.  In the longer term, there is a reasonable chance that Britain will actually be better off outside the EU, but the short term transition to a new relationship with Europe will cause some pain, so on balance, there are economic and investment arguments for both sides.  Set a position in GBP based on the long term strengths of the UK economy either way, but be aware that as the world gets used to an exited Britain, currency volatility will continue.  Or stay on the sidelines if you don’t want to experience the volatility. 

Summary: As long as the GBP remains above 50p against the AUD, it represents strong value in our view, but the Brexit impact has world markets polarised, so volatility will continue.

Timeframe: A “no” vote will see the end of volatility in July, while a “yes” vote will result in volatility for the remainder of 2016 at least.

2. The US election

The closer Donald Trump gets to seriously challenging Hillary Clinton, the more potential there is for volatility in equities and currency markets.  This isn’t a political issue, that is, its not about Republicans vs Democrats as much as it is the polarising impact that Trump tends to have. 

Markets don’t like uncertainty, and while much of Wall Street opposes Clinton’s stance of financial sector reforms, at least with her they feel that they know what they will get.  With Trump they feel less certain of what will actually happen, particularly with regards to foreign affairs.  And the real economy will be impacted too as businesses choose to put off investment decisions pending the outcome. 

Summary: The closer the odds of a Trump win, the greater the volatility.  Look for opportunities to set long term positions in USD where the AUDUSD trades above our fair value range of 65-70c.

Timeframe: Still a long way for this to play out with the US election in November.

3. Fed watch

The US Fed has stated that the timing of their next increase in rates will be “data dependent”, which typically means that they are looking for economic data to show that the economy is continuing to improve.  At present, markets are pricing in one more increase in 2016, with the odds of a second increase rising and falling with the news cycle.  We remain of the view that there will be only one increase during the rest of 2016. 

Most data in the past few months has been positive, without being exciting.  Last week’s payroll data, a measure of the new jobs created in the economy in the month of May, showed the weakest growth rate in five years.  Markets reacted by selling the USD against most currencies and US yields fell to recent lows.  Monthly economic data, particularly when so out of step with other indicators, should be watched with interest but do not make a trend.  To illustrate how volatility in one month’s data can be created, the US’s payroll data showed just 38,000 jobs created in May, down from 112,000 in April, but 35,000 workers were on strike at one company on the day of the survey.  While this wouldn’t have made all of the difference, it goes a long way. 

June’s payroll figures are likely to show a rebound therefore.  That said, there is one possible cause of a real fall in job growth - growing political uncertainty, as Trump gets closer to the White House.  So if hiring has slowed and June’s payroll figures are also low, we can expect US yields to fall again and the USD to be sold off. 

Summary: June will be a big month for data.  If recent positive momentum continues, yields and the USD will bounce back.  Fair value range on the 10 year US Treasury bond is 1.7%pa to 1.9%pa in our view.

Timeframe: Fed watch has a long time to play out yet, probably as long as to the end of 2017, but the impact of election on the real economy will be better understood as soon as June/July this year. 

4. The Australian election

Only really an issue for the AUD, and relatively meaningless in terms of the differences between the parties, but should there be rising concerns about rising spending by either or both parties, currency traders will get nervous.  Australia’s prized AAA credit rating is a major driver of inbound investment flows and therefore the strength of the AUD.  Our fiscal outlook is weakening and the warnings from the credit ratings agencies and agencies such as the IMF have been getting louder - keep your deficits under control or risk losing your rating.

Summary: A change in the rhetoric by either party toward more spending, in order to buy the swing vote, will lead to more volatility.

Timeframe: Less than four weeks to go, but the risk of spending promises rises as the election date approaches, particularly with a tight outcome expected.

5. Weakening Australian inflation

The Australian GDP data last week was a classic tale of two economies: output is growing at an average pace, but we are getting paid less for that output, as shown by the National Income figures.  Wage growth is at its lowest point since the last recession we had, in 1992. 

Much like the US, while our headline employment figures tell a story of a strong economy, the headline is misleading and job growth has been zero since November last year.  Low wage growth and price pressure elsewhere in the economy suggest that the RBA needs to lower rates further to stimulate the economy and avoid the same disinflationary plague that has undermined business investment and credit growth.  Even the output growth in the GDP figures is misleading, as 1% of the 1.1% growth figure came from net exports, much of which was the increased output from mining operations established during the mining investment boom.  Exports, while a good look on paper, do nothing for supporting price growth in Australia and when the price received for those exports is falling, it also does nothing for the income of Australian companies and employees.

Summary: The RBA has reiterated its support of the 2-3% inflation target, and while the incoming governor Philip Lowe may have a different attitude, he has also made it clear that if rates need to be reduced to achieve the inflation target, he will push them lower and keep them there. 

Timeframe: The June quarter CPI release will be very closely watched as it represents the likely deciding factor between further cuts in interest rates this year.

6. China data

China has a slew of economic data coming out this week.  Trade data is out on Wednesday and while the headline will likely read that their net surplus (export receipts over import costs) has grown, this hides the fact that their import prices (chiefly commodities) have fallen steeply.  Its export volumes, not value, that is more important to get a picture of the long term health of the economy.

Industrial inputs are expected to fall off sharply from the stimulus fuelled levels earlier in 2016, but consumer products are expected to remain strong.  Producer prices (“PPI”) data is released on Thursday, with an increase expected by markets, but the risks are to the downside in our view, and a sharp decline in the PPI data will put negative pressure on the AUD, as it implies lower demand likely for commodities. 

Then on Sunday, Beijing releases its data for industrial production, retail sales and fixed asset (property, infrastructure and equipment) investment.  Expectations for industrial production and fixed asset investment are low already, but retail sales is an important release.  The Australian economy is increasingly dependent upon consumer spending out of China, in particular education and tourism, so this is an important release for the outlook for Australia and if out of line with expectations, could move the AUD sharply, one way or the other.

Data quality is the biggest issue for China.  We tend to look at more reliable sources such as electricity production, freight movements and trade.  On the trade front, trade figures from Japan and South Korea provide a bleak view of the likely shape of the Chinese economy in Q2: Japan’s exports to China fell 7.6% compared to the previous year; South Korea’s were down 6%; and Taiwan’s by 10.9%. 

Summary: China remains the largest risk to the Australian economy, and markets are very sensitive to this.  A shock on any point of data will trigger a move in the AUD.

Timeframe: While there is a lot of data this week, this really just means that volatility could be higher this week.  The sensitivity to the Chinese economy will remain a feature of the AUD for the foreseeable outlook.