AUD/USD Could Hit 0.60

Summary

• Australia’s record current account surplus, supported by a commodity boom, has been unable to boost AUD.
• China woes are yet to weigh fully on AUD. A stronger concentration on an impending global growth slowdown would likely reconnect the two.
• The Reserve Bank of Australia (RBA) will likely disappoint market implied terminal rate pricing; the two-year interest-rate differential could widen another 35bp, in favour of USD.
• Hedge funds are in relatively light shorts, AUD is only 5% undervalued on a PPP basis, while momentum models remain bearish on the currency.
• We are 6% from GFC lows, 14% from Covid-19 lows, and 26% from the lowest levels AUD/USD has reached this side of the millennium.

Market Implications

• AUD/USD could fall to at least 0.60.

Introduction

The USD went on a rampage this summer, taking no prisoners (Chart 1). GBP (-11.3%) and SEK (-10.6%) were hurt the most, while G10 FX, on average, fell 7.2% against the greenback. It is no surprise though; we had pointed out that USD tends to appreciate following peak US inflation. But will the massacre continue into Autumn? Bilal thinks EUR/USD is destined for 0.90 while, at this juncture, he prefers being neutral GBP/USD (instead, he fancies being tactically short EUR/GBP). Here, we will consider the outlook for AUD.

AUD Not Benefitting from Record Exports

Australia is running a current account surplus for the first time in just under 50 years, and in record size too (Chart 2). It has come with a record trade balance (Chart 3). However, the trade-weighted AUD has failed to benefit. This is, in part, due to a failure to convert the record revenue to direct investment, with investors preferring smaller portfolio investments (Charts 4 and 5).

China Woes Yet to Weigh Fully on AUD

It is no secret that the zero-Covid has restricted Chinese growth (we have been tracking it – China Growth Tracker; Bert’s China Monitor). However, the news has not hit AUD valuations (Chart 6). It is likely because China’s trade has not yet collapsed (Chart 7). However, a stronger concentration on the impending global growth slowdown would likely reconnect the two.

Widening Interest Rate Differentials Will Hurt AUD in More Than One Way

The interest-rate differential will not help AUD either. We have been hammering home (with Dominique starting in April) that the market is under-pricing the Federal Reserve (Fed). We believe that the Fed Funds rate needs to return to at least pre-GFC levels (5.25%) while Dominique has her eyes set on a more sinister 8% Fed terminal rate. This means that there is room for the US two-year to sell off further (we also see room for a deeper curve inversion). In contrast, we see the Reserve Bank of Australia reaching a 3.5-3.6% terminal rate. This is lower than market-implied expectations. As a result, the two-year interest rate differential could widen further in favour of the USD, with 100bp (35bp wider than now) a reasonable expectation (Chart 8).

A more hawkish Fed has repeatedly killed hopes for a goldilocks outcome. As a result, equities have suffered and VIX has been able to rise from the low-20s to near 40 (Charts 9 and 10). We think equities have plenty more downside, while it would be a surprise to think VIX remains subdued through the rest of the year. It suggests AUD has further downside, though we do not doubt that the VIX (and AUD) could see some reprieve before staging another leg lower.

Models Suggest Further Depreciation Could Continue

Hedge funds are net-short AUD, but in quantities far from extremes (Chart 11). Meanwhile, AUD/USD is 5% below its PPP implied value – far from undervalued (Chart 12). In fact, all else equal, AUD/USD would have to fall below 0.60 for it to be undervalued, by our calculations! Lastly, momentum models are bearish AUD/USD and have returned, on average, 2.7% over the past three months.

We Are Some Way Off Historical Lows

Unlike EUR/USD (attracted to a magnetic parity level), AUD/USD is not constrained by close technical levels. It would take a further 6% fall for it to get back to GFC lows, while a 14% move would have it back to Covid-19 lows and a 26% move would have it to its lowest level this side of the millennium (Chart 13).

Market Implications

A multitude of factors helps host a bearish AUD view, though in the short-term we may see some reprieve as markets turn their eye from the risk-appetite destroying Fed cycle. However, it should not stop an eventual continuation of AUD/USD’s downward spiral, with 0.60 far from unrealistic.

Ben Ford is a Researcher at Macro Hive. Benjamin studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

(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.)