Tuesday 28 November 2017 by Guest Contributor Opinion

The AUD – caught between a rock and hard place

On the ground in the US, currency economist Greg Gibbs gives us a fantastic view of the political landscape, the prospects for the USD and more importantly the AUD in 2018


This has been one of the worst years for the USD for some time and the AUD has been rather directionless against it over the last year. Looking to the year ahead, it is very hard to get enthused about the AUD, it’s been left in the dust by a rebounding EUR and its Asian currency peers. We see more downside risks, but you can’t count it being down and out against the USD which faces its own hurdles.

AUD performance against other currencies and Trade Weighted Index year-to-date

Figure 1

20/20 hindsight

It is hard to explain why the USD had been so beat up this year. greggibbs

The Fed has picked up its pace of rate hikes, US short term rates have risen faster than most to new cyclical highs, and the Fed has started to reduce its asset holdings; let’s call it quantitative tightening.  The main negative is that US inflation fell surprisingly. Even so, the economy has retained its strength, and in fact, strengthened more than expected this year along with the labour market tightening beyond its equilibrium.  Furthermore, the US Congress and Administration are working on major tax reform that promises to supercharge the US economy.

With the benefit of hindsight, we can rationalise the fall in the USD this year.  The economic recovery has gone global, becoming stronger and broader, and we are in the midst of a global asset melt up.  Capital has been chasing growth assets around the world and capital that had been parked in the US is moving out, mainly to equities in Europe and Asia. Currencies that are more often beholden to interest rates are instead taking their cue from equity capital flows.

This may well remain an underlying theme for another year, especially if global inflation remains subdued and investors show little fear that central banks might take away the punchbowl. 

Not counting the US dollar down and out yet

Then again, you can’t just disregard the USD when against most currencies it now looks stretched from its improved interest rate and yield advantage. Passage of tax reform may give the US economy a big boost when it is already close to, if not beyond, its productive capacity. 

USD down in 2017 even as US rates accelerate higher

Figure 2

The Fed may have to raise rates more than expected next year, which may lift the USD. If inflation does rear its head and the market fears that the Fed has gotten behind the curve, it might pull the rug from under the global equity market by raising rates faster than the market expects,   causing a rush back out of emerging market currencies to the relative safety of the USD.

The gold rush is in Europe and Asia

However, it does not appear that this risk is front of mind for the market as we cruise into the end of 2017 and investors cast their eyes over what might happen next year.  Most seem more worried about missing out on the gold rush that is Emerging Markets (EM), European and Japanese equities.

When there is gold in the hills, investors want to believe that US rates will rise slowly and stop before too long, well below historical norms, leaving global stock prices to climb steadily along the projected paths of increasingly confident analysts..  Investors want to believe that the USD will continue down its slippery slope and grease the flow of capital into the promised land of other countries’ better valued equities. Investors are not, at least not yet, seeing potential tax reform in the US as a reason to buy the USD.

Darker forces hurting the dollar

But there is another darker reason why the USD is struggling this year, and may fall much further; the increasing uncertainty over the stability of the Trump administration and the loss of the most respected stewards of the Federal Reserve.  If the USD has struggled this year, it may be completely toasted if Trump is forced up against a wall by the Mueller investigation and confidence in the Fed collapses.

The Fed loses a wheel

Most commentators in the financial press have cited the change from Yellen to Powell as  a seamless ‘business as usual’ affair. Not much to see here, move along.  However, the USD reaction so far suggests that the replaced wheel is not quite as stable.  In the meantime, several other wheels are in the process of being replaced.  The market can't be sure that the new Fed won't wobble and veer off the road if it hits some curves.

The best that people have to say about Powell is that he has appeared to back Yellen.  But it’s damning praise; we can't be sure of a leader who has had little to say other than "what she said".  He may be a good committee leader, but the committee is all over the place.  At least when it couldn't make up its mind in the past, Yellen could blaze the path. 

Worse still, one of the more trusted Yellen lieutenants, New York Fed President Dudley, arguably the next most capable person at the Fed, has called it quits.  It looks a bit like the smarter rats are jumping from the sinking ship. 

And why is Trump booting Yellen in the first place?  That is a question that doesn’t have any comforting answers.  And who did he happen to choose among the candidates placed before him?  The one who  appears to be the least hawkish and most malleable. Commentators may have offered comforting words for the change of Fed leadership, but one wonders if it is all a bit too politically correct. The reality is that the Fed leadership is suddenly looking out of its depth.  When push comes to shove, who will call the shots and what will the Fed do? We don't know the answers yet and that could leave the USD floundering.

Political chaos

Then there is US politics. It is getting harder to predict what Congress and the Administration might do. The Republicans are fighting each other for the soul of the party, and are perhaps too desperate to pass a tax bill to salvage the mid-term elections in November 2018.  Trump is polarising the electorate, his own party, and battling against an investigation that threatens to grind his government to a halt and distract Congress even more. 

There is a growing sense of chaos in government and in society, as home grown gun violence goes unchecked and high profile actors, business people and politicians face sexual harassment or assault claims. Trump is attacking the NFL players and establishment, CNN and some of his own party’s senators, calling for a wall or a travel ban, or further Clinton investigation whenever he needs a distraction. 

Furthermore, the special Alabama Senate election on 12 December brings sexual assault claims and Republican Party divisions together in an ugly mess. The party is not even sure if it wants to win the seat or not.  

There is also the rolling problem of Continuing Resolutions to fund the government and raise the debt ceiling, into which Trump may try to gain funding for his wall and use a DACA (‘Dreamer’) bill as leverage. Politics was messy and dysfunctional before Trump.  It now has a sense of the bizarre, making it hard for the market to buy into the idea that the government can deliver a comprehensive tax reform.

With the mid term election approaching next year, if tax reform is delayed and debate inside the Republican Party gets acrimonious, the market may well sell down the USD further.

If nothing significant is passed to salvage the Republican hold over Congress in the November midterms, the US government may appear even more out of control.  Imagine what could happen if the Mueller investigation heats up and Democrats control one or both houses of Congress.  Talk of impeachment may well become all the rage while Trump will counterattack by firing up his Alt right supporters.  The political drama could send investors fleeing the USD in droves.

On the other hand, Republicans still control both houses of Congress.  And they know how important it is for them to get a tax bill passed soon.  They could do so and this might be all that is promised;  bring back US company investment to US shores and drive up growth, productivity and confidence in the US economy. These promises could boost Republicans in the polls in time for the mid-terms and until then, the USD might prove to be a strong currency again in 2018. 

At this stage, the market appears to be building against more USD political risk and focussed on investing in global equity markets with capital flowing more readily to Asia and Europe.  This strategy has worked so far this year and will tend to dominate until investors can be sure Republicans can coalesce around a tax reform plan.

AUD dogged by that ‘Old World’ tag

Coming back to the AUD; its performance has been lacklustre in 2017 against the troubled USD and like many currencies, its yield advantage has diminished against the USD.  This has not driven the AUD lower, but it is starting to drag on the currency, especially against other currencies in Asia and Europe.

AUD yield advantage going, going….gone

Figure 3

As we approach 2018, a rate hike in Australia appears to be more easily pushed forward into the murky future.  The market can now foresee US cash rates rising above those in Australia in the next year – the first time this might happen since 2001, when the AUD was trading around its record lows at around only half of one US dollar.  The whole Australian yield curve looks at threat of falling below that in the US in 2018.

Alone, this might not seem such a problem in a world where equity flows are playing a dominant role in currency direction.  However, Australian equities are not that attractive either.  Investors want exposure to IT companies and disruptors and Australian equities are not attracting the same buzz as high tech companies in Asia; not dissimilar to the old world tag that dogged the Australian economy and its currency two decades ago.

The Australian share market has underperformed major equity and EM markets year to date; sitting only just above the UK share market that has been held back by Brexit uncertainty.

Major country and EM equity indices year-to-date – Australia lags

Figure 4

MSCI global sector indices – High Tech leads, energy lags

Figure 5

Australia leveraged to old China growth drivers

Australia appears to be leveraged to the old economy in China (heavy industry and construction).  The market now views China as a leader in high tech industries and increasingly led by services sector growth and consumption expenditure.

Construction and fixed asset investment in China are still significant and support commodity demand. However,  fixed asset investment growth has slowed and has been declining in importance as China looks to modernise, reduce pollution, and control speculation in the property market.

Tightening financial conditions in China

The AUD has also been used as a proxy for Chinese financial risks.  Recently, Chinese corporate bond yields have been rising.  Negotiable Certificate of Deposit (NCD) rates have also risen, evidence that funding pressure on wealth management products (WMP) is tightening.

China announced plans to introduce new rules in 2019 designed to reduce excess risk taking, leverage, and moral hazard in WMP.

China NCD and longer term interbank lending rates firm

Figure 6

China corporate bond yields rising again recently

Figure 7

It's not the full redux

The old vs new economy theme sent the AUD to record lows in the early 2000s.  In the wake of the Asia currency crisis in 1998 and before China emerged to drive a commodity boom, Australia truly did appear to be left behind by the then ‘dotcom’ boom.

Asia is now widely seen as the most dynamic region in the world, and Australia has and continues to benefit from solid growth in the region, including for its education and tourism services and property. Immigration has driven a faster rate of population growth in the last decade (1.6% in the year to March-2017), supporting construction and overall demand.

The Australian economy is forecast by the RBA to grow somewhat above trend for the next two years supported by strong government infrastructure spending and recovering non mining business investment.

Australia’s external balance is stronger since the mining boom, boosting its net export performance.  As such, the AUD should not need as much additional yield support to sustain its value as it used to.

Australia’s external balance %GDP - improved

Figure 8

However, the nation is also dealing with relatively high household debt and a slowing housing market. This represents a significant structural headwind and appears to be dampening consumer confidence and spending.

Political risk in Australia

Political risk is playing a part in Australia.  The government’s majority is razor thin after a dual citizen crisis forced several MPs out of office.

In one of two bi-elections in December, the ruling Liberal National Coalition member forced out of parliament for having dual citizenship is facing a tough battle for re-election on 16 December.

It is possible that more dual citizen bi-elections will be held next year.  In any case, a national election is likely in August next year (if not sooner), and a change of government appears likely.

Neither side of politics is inspiring public confidence, and the Labor Party is proposing policies that may undermine confidence in the housing market that is already slowing.

The AUD outlook is not particularly rosy and much depends on the USD. We can see it lagging many other alternative EM and major currencies next year if the USD resumes its 2017 downtrend.  If the USD does find its feet, perhaps with tax reform success, we see AUD leading the decline against a resurgent USD.