It’s never a dull moment with the Kouk:
With the market all but pricing in a 1.75 per cent cash rate, the 3 year bond yield hovering around 1.90 per cent, 10 year yields around 2.50 per cent and the Australian dollar US$0.78 or so, it is time to look for the next trading opportunity.
It’s time to position for a back up in yields in the bond market and a change in the current market pricing for the RBA cash rate. This change in view is not based on any radically different view on the domestic economy – right now and in the near term, things are still very soft, growth is set to remain below par and there still seems to be a rate cut or two in the RBA’s kit bag. The issue is that the interest rate markets now finally know this and have more or less moved to where I thought they might get to. It is now prudent to start thinking about how markets will trade over the next year and lower yields and a lower AUD from here seem less likely than a rise.
For the AUD it is a similar theme, even though it has not broken below US$0.75 as seemed likely not that long ago. It may still dip below US$0.75, of course, but the balance of probability trading benchmarks are tilting away from a bearish AUD outlook to a more neutral position. It wont take too much to see a mildly positive set of benchmarks emerge for the Aussie dollar in coming weeks and months. It is important to note that the AUD did fall a smashing 34 US cents from its peak level in 2011 so getting bearish after such a move is a mugs game.
It now seems the conditions underpinning the gloomy forecast for the cash rate falling to 1.5 per cent by end 2015 are fading. It still may well happen, but from a trading perspective, when 1.8 per cent is priced it, the return from being right has to be locked in and consideration now must be given to a reversal. It’s a view with a long run horizon. That consideration has lead me to put on trades that profit if the RBA ends the easing cycle with a cash rate at 2.0 per cent (or 2.25 per cent of course) and / or we get to the position where interest rate hikes start to be priced in, let alone delivered by the RBA, during late 2015 or 2016. With these trades, the losses from the RBA cutting to 1.75 per cent are trivial and form part of the trading risk-reversal strategy. Of course the trades lose money if in fact the RBA cuts to 1.5 per cent or less.
It is a scenario where the implied yield on 3 year bond futures, for example, are targeted to rise from current levels around 1.90 per cent with the 10 years also seeing a higher implied yield than the current 2.50 per cent.
It is always, always, always, always difficult to pick bottoms in currency markets, but that is what I am trying to position for with the Australian dollar. It is now time to think about getting cautiously long, and anticipate some greater risk of a return to US$0.80 and even US$0.85 than a scenario of a sustained break towards US$0.75. Trades that profit from the AUD ending 2015 at US$0.8250 and higher seem to be risks worth taking.
I still think the economy is negotiating its way through dreadfully difficult times. The collapse in mining investment, a sharp decline in the terms of trade, generally gloomy business and consumer confidence are all acting as constraints on a return to above trend growth. When a soggy global economy is thrown into the melting pot, it is easy to see why the RBA needed to edge interest rates lower.
That said, there have been some interesting, and important, moves in markets in the past month or so. The ASX has trended sharply higher which will boost wealth, confidence and purchasing power of the household sector. There has even been a small rise in some commodity prices in the past month, albeit from extraordinary lows. Any further gains would of course be good news for the Australian economy.
At the same time, fiscal policy seems set to be positioned more towards growth than a budget surplus, meaning government demand will be kicking in a touch more to bottom line GDP through 2015 and probably into 2016 than was the case in previous years.
Globally, the recent news from the Eurozone has been a little better, admittedly benchmarked against dismal expectations. The US growth cycle remains solid, and India is enjoying a strong cyclical rebound in activity. China is always a difficult call, but the authorities seem to be positioning the economy for 7 per cent growth which would be a good outcome. Japan appears to be exiting its mid-2014 recession with the Nikkei scaling fresh cyclical highs at long last.
In Australia, consumer demand growth remains a little below trend but with household wealth surging on the back on house prices and the stock market, it would not take much to witness a sharply stronger pace of consumption growth over the next quarter or two. A record number of new dwelling starts should also feed into a pick-up in retail spending with the construction surge itself is a significant positive for domestic growth.
And those dogged house prices, which looked like cooling off in the second of 2014, have shown remarkable resilience with annual growth still hovering around 8 per cent. This is still too high for everyone’s liking. While house price growth is more likely than not to slow further during 2015, the RBA has expressed concern and discomfort at the time it is taking to crimp those house price gains. This may have a high weighting in RBA thinking and actions, making it hard for the Bank to deliver a cash rate below 2.0 per cent. This is just another issue that is behind my view change.
Of course, the big issues for monetary policy and the markets are inflation and the labour market. Inflation is low and is set to remain low aided and abetted by record low wages growth and rising unemployment. The issues were fundamental to the recent rate cut and the current market pricing. But if the early signs of a turn in the growth profile turn into a pick up in activity later in the year, the unemployment rate may peak around 6.75 per cent before falling. And recall, the market is currently pricing in almost two full rate cuts in anticipation of more news of weak growth and any upside surprises to jobs and inflation will see that pricing change.
THE BOTTOM LINE
This change of view may be a tad premature, but such is the nature of markets, it often pays to get in early. When more and more market commentators are now getting bearish on the AUD after a 34 cent fall, it is a signal for a change in view on the AUD. So too with interest rates. Those calling for interest rate hikes late in 2014 and now calling interest rate cuts when they are fully priced in. Again, this is often a sign that the turning point, in the other direction, is near.
Actually, I was under the impression that catching a falling knife was a mug’s game…
I’ll take the other side of that bet. Rates will go lower this year and the dollar will reach 70 cents. Next year there’ll be more rate cuts and a dollar at 60 cents. And bond yields will fall throughout.