Australian Dollar Debate – up OR down?

March 30, 2012

FOREX

My piece yesterday where I declared myself now a bear on the Aussie Dollar in a medium term sense expecting it to trade under parity at some point as opposed to breaking back higher elicited some interesting direct feedback from readers and mates in the markets via email.

The primary discussion was two fold:

The first point if contention was the question of just what is the outlook for the global economy and isn’t China really more important anyway – which of course then morphed into a debate about China. The point was made again strongly that it is a slowdown in the rate of growth of China not a slowdown in China which would be distinctly different.

The second point of order was on use of and applicability of Aussie Dollar valuation models. How they are constructed, fitting them and long term use.

I think the models cover this and will get to it later but first lets look at a very timely article that the FT’s Alphaville blog ran a piece last night about this very China and Model debate.

SocGen vs Citi: the Aussie debate

Posted by David Keohaneon Mar 29 19:25.

Having for so long been the darling of the high-beta FX world, the Australian dollar is having a bad time of it recently. It has been beaten down some 4.4 per cent versus the dollar since the start of February and lost 3.8 per cent against the yen since March 20.

The Aussie has suffered from a toxic mix of weakening Chinese demand (and the prospect of further weakening to come), a central bank that likes to ease and may cut rates again when it meets next week, and a dodgy economic outlook – Australian treasurer Wayne Swan warned on Wednesday that weakening revenues mean the government may need to implement steep spending cuts to balance the budget.

However the Aussie’s prospects are the subject of some marked disagreement, most of which boil down, unsurprisingly, to China’s prospects — although we note not everyone agrees that the Aussie is still tied to China’s fate.

Yep that is the key at the moment because no one really knows what is going in China but many fear that the growth profile is not only slowing but has weakened – in some cases they believe weakened materially. In the Alphlhaville story Citibank says that

Given how negative discussion on AUD, China and commodities has been recently, it may be surprising that its usual drivers suggest that it is significantly undervalued. In fact, relative to our equation for AUD, the degree of undervaluation is as large as it has been over the last 40 months…Figure 1 shows the estimated values of our AUD model and actual AUD. The model suggests that AUD should be trading about 3 per cent higher than where it is now. 

It’s interesting that the NAB model Pete built isn’t as “fundamentally” undervalued but then it has different drivers to the Citi model which uses

… nominal 10yr rate differentials between Australia and the US, real interest rates in Australia and the US, oil and non-oil commodity prices, the VIX, and the 1yr CNY NDF. These are pretty standard inputs. The most significant variables are commodity prices, the rate differential, the VIX and the 1yr NDF. All have the expected sign.

Are they standard? That’s an interesting question, I would posit that they are a different way of representing my 5 drivers and the inputs into the NAB model. So yes they are standard but not exactly what everyone might use. Certainly I think 1 year Chinese NDF’s might be problematic and I wouldn’t use them, but I get what they are aiming at.  Having said that though Citi believes them enough to signal to clients, and the market they are going long (buying) Aussie Dollars against the US Dollar given,

there is a tactical opportunity to buy given increasing undervaluation relative to its fundamental drivers following the recent intensification of negative sentiment surrounding China. As we discuss above, AUD undervaluation is as large as it has been over the last three years, potentially signaling a coming bounce.

Further, we feel that risk-reward may be skewed in favor of a stronger response to strength in the Chinese PMIs this weekend, which means there is vulnerability for a reversal of sentiment on the region.

Now there is nothing wrong this rationale at all – but for me to use a long run valuation model to take a punt on Chinese PMI’s this weekend just doesn’t fit my risk tolerance or profile.

But as a trade and given the candlestick from yesterday/last night’s trade Citi and others are taking the punt. As you can see in the chart below the Aussie Dollar is in a big old down trend this month and last nights low and bounce looks very much like a hammer! which is a bullish reversal and the MACD indicator has crossed over as well . So they might be right for a trade and they do say its only tactical.

Now back to the debate in on China via Alphaville

Now, from Société Générale:

The source of particular concern is China, where the latest news flow continues to point to weaker output, and weaker profit growth. That reinforces our belief that the most vulnerable of the major currencies to deterioration in risk appetite will be the Australian dollar. It is the [most] highly-valued major currency and the one most vulnerable to a Chinese hard landing. AUD/USD has dipped back below its 200-day moving average and looks vulnerable for a drop towards parity if the mood deteriorates further.

More succinctly from SocGen’s Kit Juckes: “But in my life, for AUD. Stay short.”

And, finally, an attempt by Rabobank to guage currencies under/over valuation which finds the Aussie is overvalued according to all four measures with Bloomberg’s CPI putting it 22 per cent over the top:

Of course, PPP deviations can persist for a very long time, and as Kenneth Rogoff said (and Rabobank quoted): “While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates.”

Anyway, we know it’s not all that uncommon for banks to disagree. We just thought we should mark the difference. Someone has to be wrong.

So having gone for a very long period where the merits of the Aussie were writ large and hardly debated at all and the firm belief was that all things Aussie related were rosy we are seeing a little more questioning start to emerge around the globe.

This is the very nature of range trading markets though isn’t it – some people are bullish and so buy it while others are bearish and so sell it. We end up with a defined top and bottom and even though these might be wide ranges and there is still money to be made for traders over different timeframes they remain ranges nonetheless. The chart below is a monthly Aussie Dollar chart going back 15 years – the boxes are the ranges.

The debate rages and the jury is out – will China, won’t China slow or grow. How slow will Australia grow, what will Wayne Swan do with the budget, what can he do, what is the fiscal position going to look like and thus how much extra slowing on the economy will this induce.

My longer term monthly view is summarised by the box on the right of the chart above – that is a big old range trade. Shorter time frames will differ obviously as the market and sentiment ebbs and flows.

Valuation wise I am distinctly in the China slowing camp, the US Dollar strengthening camp, the commodities coming off camp and the Australian interest rate cuts camp. All of which should feed into these models and drive lower valuations for the Aussie in time.

The debate rages.

Have a great day

Gregory McKenna

www.twitter.com/gregorymckenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If however you do need advice on Investments, Economics, Funding and Liquidity, Interest Rates and Forex and Derivative markets we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

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  1. China – not so bad, risk on again? Australian Dollar up? | Lighthouse Securities - April 1, 2012

    […] that is hardly going to matter given the China debate that is going on at the moment and which I covered in last Friday’s piece. My guess is that the bulls in the China shop will have the upper hand for a few days and that this […]

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