Asia | China | FX | Monetary Policy & Inflation | US
AUD displays one of the most pro-risk characteristics among the G10 currencies. It has historically been very sensitive to base metal prices and economic growth in Asian economies. And a strong reliance upon commodities (mining represents almost 10% of GDP) has led to higher wages and inflation pushing nominal rates higher. Indeed, Australian interest rates have generally been higher than those in the major economies – in the early 1990s, the interest rate differential between Australia and the US was almost 5%, pushing investors into the ‘Australian carry trade’.
Although interest rates differentials have collapsed since 2012, the risk-on characteristic of the AUD has remained part of its DNA. This year, the AUD has been one of the assets most correlated to the S&P 500 (Chart 1). During crisis ‘all correlations go to one’, but AUD’s rebound has perfectly matched the S&P 500 one, ignoring the USD/CNH spikes.
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Summary
- AUD is the currency most correlated to the S&P 500 since the pandemic began and has ignored the deterioration in Australia-China relations.
- RBA is finally doing proper QE, but the BoP dynamics are what’s driving AUD
Market Implications
- Short term – Neutral AUD, given the positioning and the global recovery slowdown.
- Medium term – Positive AUD, given the improved BoP and USD vulnerability.
Introduction
The 30% bounce in the Australian dollar from March has been remarkable, making it the best commodity currency in 2020. But this rise raises a few questions:
- Is the correlation with the S&P 500 sustainable?
- Will AUD be more sensitive to the relationship deterioration with China?
- Are the medium-term factors supportive?
A Very High Correlation With the S&P 500
AUD displays one of the most pro-risk characteristics among the G10 currencies. It has historically been very sensitive to base metal prices and economic growth in Asian economies. And a strong reliance upon commodities (mining represents almost 10% of GDP) has led to higher wages and inflation pushing nominal rates higher. Indeed, Australian interest rates have generally been higher than those in the major economies – in the early 1990s, the interest rate differential between Australia and the US was almost 5%, pushing investors into the ‘Australian carry trade’.
Although interest rates differentials have collapsed since 2012, the risk-on characteristic of the AUD has remained part of its DNA. This year, the AUD has been one of the assets most correlated to the S&P 500 (Chart 1). During crisis ‘all correlations go to one’, but AUD’s rebound has perfectly matched the S&P 500 one, ignoring the USD/CNH spikes.
Yet that relationship could change. Price action over recent weeks has been less encouraging. Overall, risk FX pairs such as the AUD/USD or the AUD/JPY have reacted much less to the S&P 500 rallies.
You could argue that the short positioning in AUD has now corrected or that China outperformance is now priced in. But you could also say that the central banks’ race to the bottom this year and their commitment to keep rates low for longer has changed the DNA of several currencies. And as such, risk-on pairs such as AUD/JPY or CAD/JPY may exhibit different volatility from before.
And With China
AUD resilience this year was also remarkable despite the deterioration of Australia-China relations. Indeed, the Australian economy depends greatly on China, and trade with the country has grown rapidly over the past decade. Today, China is Australia’s most important trading partner and accounts for 39% of its exports (the second-largest partner, Japan, accounts for only 9%). China buys 80% of Australia’s iron ore as urbanisation and the housing boom there boost demand for the metal.
According to an RBA study, economic links via the trade exposure are the most important avenue for spillovers from China to the AUD. Indirect links are also important: demand from China increases the price of commodities that Australia exports to other countries. And the RBA noted that indirect financial links are increasingly important as well, such as investors expressing views on China via the AUD due to the relatively closed China capital account.
Much depends on the relationship with China, then. But tensions between both countries have risen since March after Australia followed the US in pushing for an international inquiry into the origins of Covid-19. In response, China confirmed the anti-dumping duty of more than 80% of Australian barley exports after an 18-month investigation (in 2018-19, Australia sold AUD1.2bn worth of barley to China). Soon after, China targeted beef (~AUD1bn), wine (~AUD1bn), coal (~AUD10.7bn) and cotton (~AUD534mn).
Despite these measures, observers expect China to avoid targeting iron ore exports. Overall restrictions could represent up to AUD14bn out of AUD130bn exports to China, which still looks manageable. Moreover, shipments of iron ore to China reached record levels in H1, hitting AUD10bn in June alone. That’s probably why the AUD has reacted little, but it’s a risk to watch in 2021.
BoP Dynamics Rather Than RBA Policy Should Drive AUD Performance
Monetary Policy
During its 3 November meeting, the RBA took further measures to ‘support job creation’ and the recovery. Among them, they cut the cash rate to 0.10% from 0.25%, reduced the 3-year government bond yield target to 0.10% from 0.25%, announced an AUD100bn longer-dated bond program (5-10 years), and reiterated guidance on not raising rates for at least three years. They also emphasized that they could do more but that negative rates are ‘extraordinarily unlikely’.
Markets appeared to have mostly priced the outcome, and therefore the AUD reacted little. Indeed, from 21 September to 21 October, AUD weakened 4% against the CAD and 3% against the NOK, despite a 2% rally in the RMB. Moreover, monetary policy will probably be a secondary currency driver in 2021/22 because fiscal policy will drive interest rates and economic growth more.
Since the pandemic began, the RBA has expanded its balance sheet much more slowly than the major central banks. It increased from 9% to 16% of GDP, whereas the Fed, the ECB and the BoC increased their balance sheets from 19% to 34%, 39% to 58%, and 21% to 36% respectively (Chart 3). Indeed, the RBA successfully maintained the 0.25% yield target on the 3-year government bond, with very little asset purchasing, due to the central bank’s credibility.
But on top of its 3-yield curve control, the RBA is now moving to proper QE with a size target (AUD100bn, or 5% of GDP), a specific window (six months) and an objective to keep long-term yields low (5-10 years). This is perhaps unsurprising given that a recent RBA study showed that QE is more effective than a rate cut to weaken the exchange rate. RBA Governor Philip Lowe said that higher bond yields have ‘added upward pressure on AUD’. But as we said, monetary policy divergence is much lower than it was, and the impact on the AUD may be limited.
Balance-of-Payments
The relationship between the Australian BoP and the exchange rate has varied over time (Chart 4). In the early 2000s, Australian’s terms of trade was rising, but the nominal exchange rate declined. Since 2017, the broad BoP has improved from 0% to 3.5% of GDP, but the nominal exchange rate has weakened by 11% (likely driven by the drop in debt inflows). All being equal, though, positive BoP dynamics are a positive driver for the Australian currency.
Three important factors supported the BoP this year: the economic recovery in China leading to a strong demand for iron ore, the drop in net services imports and the drop in dividends outflows. The price of iron rose to $120 a tonne from $90 at the beginning of the year due to a strong demand from China and supply disruption, especially in Brazil. And the services balance flipped into positive territory in Q2 for the first time on record as borders closed.
Going forward, the ongoing manufacturing recovery, persistent demand from China and the border restrictions should all leave favourable BoP dynamics. This points to medium-term strength for the Australian dollar.
Reuven is a macro strategist. He currently works for a private bank in Geneva on the strategy & advisory side. He has previously worked 4 years at Harness Investment, a $1bn global macro hedge-fund. His areas of interest are G10 & EM currencies. He holds a master of finance from Bocconi University.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)