Conclusion: We remain bearish on the Aussie dollar for the intermediate-term TREND and forsee a correction from its near all-time high (AUDUSD), primarily due to slowing economic growth down under in part aided by slowing growth in key export markets, which may lead to lower interest rates and more accommodative monetary policy.
Position: Bearish on the Australian Dollar over the intermediate-term TREND; Bullish over the long-term TAIL.
In screening for and analyzing foreign exchange opportunities, we focus primarily on a three-factor model, which incorporates real GDP growth, inflation, and the a combination of monetary and fiscal policy. Using this framework, our objective is to absorb any/all relevant data points that could help point us to the correct slopes of these factors, especially versus the perceived slopes embedded in consensus expectations.
On the margin, the factors supporting the Aussie dollar’s +28% rise since when we first turned bullish on it in June of 2009 are deteriorating and look to worsen over the intermediate term. While we remain bullish on the AUD over the long term (especially against the USD and JPY), we do think we’re setup to see some near-term weakness in the currency and are inclined to short what we feel is the start of what may be a meaningful correction, a position we introduced in mid-March (email us if you need a copy of the report).
Below we analyze all three of the driving factors individually in support of our recent call for the AUD to correct over the immediate-to-intermediate term.
We think the near-term growth data points in Australia are setup to rollover in advance of what should be a sequential deceleration when 1Q11 Real GDP is reported. This may seem contrary to our current positioning, as we are currently long Chinese equities in the Hedgeye Virtual Portfolio, but we are keen to point out the duration mismatch between the Chinese equity market(s) signaling a bottoming in China’s growth rate and Australian economic data slowing as China bottoms.
Comparing 4Q10 vs. 1Q11 on various metrics of economic data do indeed support our view that 1Q11 GDP growth will slow sequentially from 4Q10 with upside/downside risk in 2Q11 is skewed to the downside (Japan is Australia’s second largest export market at 19.2%; China is first at 21.8%). Of course, Australia’s economic growth will eventually rebound alongside China and Japan’s but near term, growth looks to poised to slow.
With the notable exception of Retail Sales , Private Sector Credit growth, and Business Confidence, Australia’s economic data has largely being trending in the wrong direction, particularly when analyzed on a quarter vs. quarter basis:
Our forecast for the slope of inflation in Australia is largely a wash. Yesterday we saw the TD Securities Inflation Index accelerate to +3.8% YoY in March, driven in part by higher crude oil prices. Still, on a quarterly basis, official reported inflation looks to continue its deceleration in 1Q11 based on the trajectory of this unofficial gauge. The current strength of the currency is also a supporting factor for a deceleration in Australian CPI and as RBA Governor Glenn Stevens recently said, “The central bank’s goal is being assisted by the high level of the exchange rate.”
Where Australian inflation data heads in 2Q11 will be largely based on crude oil prices and the resiliency of the Australian consumer, which is currently growing less resilient on the margin, based on consumer confidence readings, and that trend looks to continue over the intermediate term as lagging 1Q growth data weighs on hiring. On the flip side, we maintain our bullish intermediate-term position on crude oil prices, so Australian inflation looks like a wash at this point/we need more data to confirm a view in either direction.
Given this mixed outlook for inflation, we can be reasonably assured that the RBA will continue their hold on interest rates over the intermediate term, as the proactive Glenn Stevens has a history of being data dependent. And with growth data expected to look sour in the near-to-intermediate term, we wouldn’t be surprised if Stevens elects to cut rates. Australia is one of the few developed economies in the world that has headroom in this direction, so Australia remains home to one of our favorite equity markets, particularly in a softer policy setting. The current quantitative setup in the All Ordinaries Index supports this view.
Monetary & Fiscal Policy
As mentioned before, Glenn Stevens and the RBA have been incredibly proactive in addressing the current global surge in inflation – perhaps more so than any other central bank in recent years. As a result of their prudence, they’ve been able to wait and watch economic trends develop since their last hike in early November, rather than playing a dangerous game of “policy catch-up” like we’ve seen in India, for example.
As it relates to the slope of future monetary policy, we continue to believe that the RBA will minimally remain on pause over the intermediate-term and could potentially cut rates if 1H11 Real GDP growth comes in where we expected it to back in early December (email us for a copy of the report). In fact, Stevens called the 4.75% target cash rate “mildly restrictive” and “appropriate given the economy’s outlook”; we contend “mildly restrictive” could turn into “very restrictive” in a heartbeat – particularly if you use Hedgeye estimates for the slope of Australian growth.
While both the buy-side and sell-side are starting to sniff this out, the major risk to the Aussie dollar is that, potentially, neither side is bearish enough on Australian interest rates.
The Australian bond market, however, does appear to be bearish enough on Australian interest rates. Since rallying from putting on an impressive rally from the August 2010 lows, Australian 2Y and 10Y sovereign yields appear to have hit an invisible ceiling, falling (-27bps) and (-4bps) YTD, respectively. For normalization purposes, that equates to declines of (-5.3%) and (-0.8%), respectively.
This bullish bid for Aussie bonds is weighing on Australian swap rates – particularly at the short end of the curve. As such, the compressing interest rate differentials relative to the USD, JPY, and EUR are setup to weigh on the currency going forward.
Shifting gears to fiscal policy, we continue to favor the hawkish direction of Australian fiscal policy (a key reason we are bullish on the AUD for the long term), as it continues to distance itself from the egregious laxity showcased here in America.
Rather than use the recent flooding and cyclone as an excuse to allow government finances to deteriorate, Prime Minister Julia Gillard maintained her pledge to return the government budget to a surplus by 2013. To fund the rebuilding, her government announced spending cuts and a one-time levy designed to collect at least A$5.6B, though that tax may have to be revised upward in the coming weeks as official estimates for the damage have been revised up recently to A$9.4B.
All told, we remain bearish on the Aussie dollar for the intermediate-term TREND and expect a correction from its near all-time high (AUDUSD), primarily due to slowing domestic growth in part aided by slowing growth in key export markets, which is likely to continue to weigh on Aussie interest rates.
Longer term, however, we remain bullish on the currency due to its sober and proactive monetary and fiscal policy, in addition to its positive exposure to China and commodity prices – which are likely to remain elevated much longer than consensus thinks, based on the findings of empirical studies which suggest commodity inflation is a leading indicator for the sovereign debt default cycle.