Conclusion: We expect the Aussie dollar to correct over the intermediate term as consensus expectations for an RBA rate hike(s) over the next 3-6 months are irrational due to a pending slowdown in domestic growth. Additionally, our 2Q Macro Theme of Deflating the Inflation is incrementally negative for the AUD as the Inflation Trade unwinds.
Position: Bearish on the AUD for the intermediate-term TREND; bullish for the long-term TAIL. (ETF: FXA)
If your fund is able to take positions in currencies and you’ve been long The Great Inflation Trade, chances are you have some long exposure to the Aussie dollar. We too have dabbled over the past couple of years, going long the AUD in the Virtual Portfolio as early as June ’09 – a few months after we turned bullish on global equities and the associated Reflation Trade.
While the AUD remains one of our favorite currencies on the long side over the long-term TAIL, we cannot ignore the mounting risks associated with being long at this juncture. As such, we continue to expect a measured correction in the coming months.
Below we update our bearish thesis on the Aussie dollar. For our introductory analysis, refer to our April 6 deep-dive report titled, “Aussie Dollar Getting Long in the Tooth”.
To start let’s quickly outline the bull case, which has indeed been supportive of the Aussie dollar’s +25.6% performance over the last 12 months (second best among all currencies worldwide vs. the USD over that duration):
Hawkish central bank: Since the Great Recession, the Reserve Bank of Australia has been far and away the most hawkish central bank in the developed world, raising interest rates seven times (+175bps) to the current 4.75% - a rate advantage that has contributed to widening interest rate differentials and has made the AUD among the most attractive carry trade options on the long side. Additionally, earlier this month, the RBA increased its full-year inflation expectation +25bps to +3.25% YoY, fueling speculation about further interest rate hikes over the intermediate term. For reference, the RBA has been hold since November.
Fiscal austerity: One of the primary reasons we remain bullish on the Aussie dollar over the long-term TAIL is due to the fiscal conservatism we continue to see out of the Australian parliament. Just last week, Treasurer Wayne Swan introduced a budget that calls for an end to 23 consecutive years of spending growth, which will put them on target to deliver an A$3.5B surplus in FY13. In FY12 alone, the budget reduces the current A$49.4B deficit by a whopping (-51%)!
The Inflation Trade: One of the differentiating core tenets of our Global Macro risk management model is our acute measurement and risk-weighting of cross-asset correlation. In the case of the AUDUSD currency pair, we are measuring a positive 0.93 correlation (r² = 0.86) vs. the CRB Index on a 1Y basis. Versus the S&P 500, the positive correlation remains substantially elevated at 0.92 (r² = 0.85). While it’s true that correlations are neither causal nor perpetual, we do point out the market-positioning risk associated with r² readings in or above the 0.7-0.8 range. That is to say when the math is this high, investors are generally looking to the same global macro fundamentals to dictate the prices of the two assets in question.
As we pointed out prior, we think the support for the bull case is eroding on multiple fronts, and, as such, we expect to see a decent sized correction in Aussie dollar in the coming months. The AUDUSD currency pair is already down (-2.7%) from its 30Y-high closing price established on April 29th and we think there is more weakness to be recorded.
To recap, our bearish thesis is two-fold:
1. Our models have Australian GDP growth slowing in the near term and accelerating in the back half of the year – an acceleration that is likely to come in (-75bps) to (-100bps) shy of current consensus expectations. The slowdown in growth both on an absolute and relative basis will cause Australian interest rates to drift downward, lessening the Aussie dollar’s interest rate advantage over other currencies. Whether or not growth slows enough for the RBA to consider loosening policy over the next six months remains to be seen at this juncture. It is, however, a very contrarian risk we are flagging and we will continue to monitor it real-time.
2. Our 2Q Macro Theme of Deflating the Inflation remains a substantial risk to the Aussie dollar, as falling commodity prices are both implicitly and explicitly bearish for the AUD. Implicitly because we expect lower inflation expectations within the Aussie fixed income market to translate into lower rate hike speculation. Explicitly because commodities account for over 60% of Australia’s total exports; thus, additional weakness across the commodity complex will reduce Australia’s terms of trade (currently at a 140yr high) and create a drag on Australian GDP growth via lower Net Exports.
Regarding component #1 specifically, recent Aussie economic data has been unsupportive of market expectations of an RBA rate hike(s) over the next 3-6 months and declining consumer and business confidence is pointing to even slower growth ahead:
- TD Securities Unofficial CPI Index slowed in April: +3.6% YoY vs. a prior reading of +3.8%;
- Melbourne Institute Consumer Inflation Expectation slowed in May: +3.3% YoY vs. a prior reading of +3.5%;
- ABS House Price Index decelerated in 1Q: (-0.2%) YoY vs. a prior reading of +5% and consensus expectations of +1.6%; the QoQ decline of (-1.7%) was the steepest decline since 3Q08;
- Retail Sales growth slowed in March: (-0.5%) MoM vs. a prior reading of +0.8% and consensus expectations of +0.5%; higher interest rates are definitely slowing Household Consumption growth (54% of GDP), as 90% of Aussie homeowners have floating-rate mortgages and the aggregate consumer debt burden is 150% of their combined gross income;
- Home Loan growth dropped -1.5% MoM in March to the lowest absolute level in over a decade;
- Westpac Consumer Confidence Index fell in May to the lowest reading since June ‘10: 103.9 vs. a prior reading of 105.3;
- Employment growth slowed in April: (-22.1k) MoM vs. a prior reading of +43.3k and consensus expectations of +17k; YTD employment growth of +26.3k is the weakest Jan-Apr pace since 1999; anecdotally, mining continues to be a bright spot, while the larger retail and manufacturing sectors continue to show weakness;
- NAB Business Confidence Index fell in April: 5 vs. a prior reading of 9; and
- NAB Business Conditions Index fell in April: 7 vs. a prior reading of 9.
The Australian bond market agrees with our go-forward assessment of slowing growth, with the long end of the curve declining (-33bps) since peaking on April 11th. The short end of the Aussie interest rate curve, which is more influenced by monetary policy expectations than the long end, also declined (-13bps) over that duration, compressing the 10Y-2Y spread (-20bps) to 41bps. To be frank, Aussie bond yields breaking down across the curve alongside a compression in the maturity spread is an explicit signal of slowing growth ahead and/or lower future inflation expectations – neither of which is supportive of the RBA increasing rates anytime soon.
Regarding the Deflating the Inflation component, the following two charts are all you really need to see. While it would be incorrectly premature to say the Great Inflation Trade is over, the quantitative setups for the CRB and US Dollar Indexes suggest we are perhaps in the early innings of the Great Unwind.
While QE3 remains a definite possibility in our models (US Treasury bonds continue to trade bullish TREND across the curve), we think the mounting political pressure facing The Bernank, combined with the fact that CPI is set to accelerate, will keep him from reaching further into his bag of monetary policy tricks at the expiration of QE2 – at least temporarily. US consumers don’t buy “transient” when prices at the pump are spitting distance from $4.00/gal. Additionally, our models have US Headline CPI accelerating on a YoY basis over at least the next quarter or so, meaning that market expectations for QE3 could conceivably come down on the releases. Time will tell on whether or not this scenario plays out.
All told, the music is still playing and the Aussie dollar is still dancing – above parity with the US dollar I might add. If you’re long the Aussie dollar, don’t be caught without a chair when the music stops.