AUD/CAD Could Fall to 0.85, or Lower

Summary

• The Australian and Canadian economies are strong. However, with 30% of Australia’s exports going to China, the slowdown there is likely to be felt worse ‘Down Under’.
• Meanwhile, oil should be supported by OPEC+ intervention and the continued looming energy shortage in Europe.
• The market is implying high terminal rates for the Reserve Bank of Australia (RBA; 3.6%) and Bank of Canada (BoC; 3.8%). We think the BoC is more likely to reach the market’s view. Australia-Canada two-year spread should continue to move in favour of the Canadians.
• Seasonality paints a poor picture for AUD/CAD through September while a bearish equity market should help the currency pair lower.

Market Implications

• AUD/CAD could fall to the bottom of its channel, or even lower. This means it could soon trade below 0.85.

AUD/CAD in the Middle of its Range

The Australian dollar has come under pressure recently. Its central bank arrived late to the hiking party, starting in May while the Federal Reserve (Fed) and BoC started in March. At the same time, global growth expectations have been weakening, with zero-Covid restrictions weighing onto an already bearish China outlook. Against the Canadian dollar, weakness has lasted a decade (Chart 1). And, right now, we are in the middle of the range. We think AUD/CAD could likely reach the bottom of the range.

Australia’s Backdrop Weakens

The Australian economic backdrop has been strong, but this may be turning. Unemployment dropped to record lows in the second quarter, wage growth is strong in the private sector, while consumption has remained robust (Charts 2 and 3). However, weaknesses will start to show. The effects of monetary policy should begin to show through Q3, especially for mortgage payments. Indeed, we could see the first signs of weakness in the August NAB Business Survey (13 September). Moreover, a weakening China backdrop likely weighs on Australian exports, and, consequently, domestic growth. In comparison, Canadian unemployment remained at 4.9% SA for July while consumer spending was up 6.9% QoQ SAAR for the second quarter (Chart 4). It leaves the economy in ‘excess demand’. Meanwhile, it comes without the burden from China.

Headwinds for Commodities, But Oil May Outperform

Commodity prices surged. And while they now trade at lower levels, they remain elevated (Chart 5). For AUD and CAD, it should have meant a stronger currency, but it did not (Charts 6 and 7). Instead, markets cared more about the demand for commodities rather than supply-related price pressures.

Looking forward, easing commodity prices could likely weigh on the currencies, but we feel AUD is more at risk. That is because 30% of Australia’s exports end up in China, a country where growth is falling, which, by comparison to our own China growth tracker indices, has historically seen AUD weaken (Chart 8).

In comparison, Canada is likely to feel less pain. Even if price caps are introduced, OPEC+ would want a higher selling price while demand likely remains strong. It means CAD is less at risk.

Rates Differential Will Be Another AUD/CAD Headwind

The market is pricing high terminal rates for both the RBA (3.6%) and BoC (3.8%). We see it as more likely there will be a growing differential.

The RBA hiked the cash rate to 2.35% (+50bp) on Tuesday. But we expect they will slow down the pace for two main reasons. First, they have become more attentive to the fact that data will weaken. This is amplified, in Australia’s case, by receiving quarterly data. Markets have cottoned onto this, but not fully. Second, the latest moves put the cash rate 15bps shy of (Governor Lowe’s) neutral rate. With the central bank meeting 11 times per year, it allows for a slower pace toward the end of the cycle alongside potential pauses. It means the market implied terminal rate is likely too high, in our opinion (Chart 9).

The BoC hiked the overnight rate to 3.25% (+75bp) on Wednesday, and while the guidance was that they are no longer front-loading, they made clear that they are far from done. Excess demand, a tight labour market, core inflation above 5%, and high short-term inflation expectations, remain issues for them. This, and the fact that the US may need to hike to at least 4%, or even 8%, suggest that they will end up with a policy rate higher than the RBA.

This suggests that AUD/CAD will continue to weaken (Chart 10).

Seasonality is Not Supportive of AUD/CAD, Neither Are Our Models or the Latest Positioning Data

Issues for AUD/CAD do not stop there. We find that the currency pair has typically fallen through September with the seasonality only increasing since the bearish channel started in 2012 (Chart 11). Moreover, AUD/CAD has correlated with the S&P 500 as of late (Chart 12). We think the S&P 500 likely remains under pressure from the hawkish Fed.

Even our models and indicators point to a lower AUD/CAD. First, despite a weak AUD as of late, hedge funds are in light net-shorts in comparison to the past year. Second, while momentum models are bearish AUD and CAD (vs USD), they have been profitable only for AUD. It suggests you should follow the momentum on AUD, but not for CAD.

Bottom Line

We think AUD/CAD will continue to weaken to at least 0.85. However, we do warn of two risks to our view:

1. IRD moves against us: While we think the RBA hiking will undershoot market pricing, lagged data (quarterly) may mean it takes them some time to come around to the view. Meanwhile, the BoC may take comfort when they see data weaken further and conclude that they have done enough. As a result, the IRD could ultimately move in favour of a higher AUD/CAD.
2. Equities rally:  Some market participants think a goldilocks outcome is possible. Therefore, they might see a 75bp hike in September as a sign that peak Fed hawkishness is behind us. As a result, equities could stage a small rally and bring AUD/CAD up with it.

Ben Ford is a Researcher at Macro Hive. Ben 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.)