Risk is off, but China is still on

See the latest Australian dollar analysis here:

Macro Afternoon

Houses and Holes is right on the AUD we need to be careful what we wish for. We do not want to be a reserve currency – already we are seeing the strength of the AUD reallocating resources around the economy. HH’s post on Dutch disease a week or two back highlighted this and it surprised me that the mainstream media never picked up on Julia Gillard’s comments and is not making more of this. All we need to do is look at tourism as an example. Inbound is flat over the past half dozen years while outbound has doubled. That’s just the thin end of the wedge.

But HH’s blog lead me to have a look at the AUD and I’d have to say that, for the moment, the AUD is certainly holding up well back at .9800 and while I can see a move to .9400 or .9500 it is still the poster child of global currency markets as the leveraged China bet. If we say AUD/USD is “CHINA” and AUD/CHF is “RISK”. You can see in the chart below where the AUD/USD is the light blue line and AUD/CHF is the red line that “CHINA” is holding up but “RISK” has absolutely tanked.

When I was at NAB we built a “risk aversion” index with inputs that were important as indicators of risk appetite. It then became an input into our “fair value” model. But it worked really well on AUD/CHF and AUD/EUR which I consider to reflect safe haven style flows.

Where you see the carnage in risk off events, it is not necessarily directly in AUD/USD but in everything as correlations in all markets move to 1. You can see that here in the September 2008 to March 2009 period. I think this is the key. In a seriously risk off world there are no safe havens. All positions above index get exited and the AUD will suffer accordingly as the world’s favourite punt. That is, the size of positions relative to index weight are huge and so in exiting hit it relatively harder than other assets relative to any one days flow of trade.

But I am fairly sure that in the half decade or so since I last sat down with the world’s big investors and central banks, of our region in particular, that their affection for the AUD would only have grown given the impact of China and the resource boom. These guys won’t get flipped out of AUD positions on a whim. Most likely they will be buying if it falls into the low .90’s high .80’s region. Only a complete reappraisal of the Chinese growth/urbanisation story or massive reweighting toward a global double dip recession will threaten their long term view on the AUD.

If however we do get either or both of these events I’m fairly sure we’ll get our automatic stabiliser back. At least I hope so.

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  1. The importance of the automatic stabiliser is something I’m starting to really understand: if the economy tanks due to the popping of the housing bubble (or a long slow deflation), then the retail and construction sectors are toast.
    Thats a given, but if the AUD doesn’t drop as a result, the tourism sector could not possibly pick up any slack (lots of jobs there for unemployed retail staff and tradies) and our lack of a decent manufacturing industry won’t help when we can’t produce enough stuff for anybody, even for cheap prices.
    Or am I reading this wrong and should just stick to reading tea leaves?

    • Deus Forex Machina

      Yes, the fall in the AUD makes other sectors of the economy more competitive thus generate sales and profits and in doing so making up for the down turn in other sectors. It’s about the overall level of monetary conditions in the economy which is made up as a combination of both the exchange rate and interest rates. Relativly high interest rates (at least for mortgages) and a very strong dollar mean that monetary conditions in Australia are very tight. If the AUD was at .80 interest rates would need to be higher to get the required level of “tightness” the RBA is looking for. When the GFC hit the RBA dropped rates 300 points and the Aussie fell to .60 at one point. monetary conditions were very loose and so with a little help from the Government’s $900 and China’s stimulus program the stabilisers kicked in. A floating rate currency and a central bank that knows how to use it are a real boon to our economy and its flexibility. It’s one of thee reasons we have gone 20+ years without a recession.

    • Not just tourism. Education and many other non-dirt exports get a kick from a “more competitive” dollar. Everyone up the supply chain from there gets to share in the love too. Ask for opinions of where a currency should be and the old saying of “one man’s trash is another man’s treasure” springs to mind.

  2. DFM,

    I’ve really got to wonder what effect the current Australian official interest rates are having on the attractiveness/”strength” of the AUD, in that holding AUD still gives decent returns.

    As a result, what effect do you think a decreasing AUD interest rate would have on the value of the AUD (I guess, relative to USD, but whatever…)?

    My thoughts are that it would drop, but I would like to get your take on it.

    (Disclosure: i ask because I figure that a slumping Aussie Housing market will cause the RBA to drop interest rates (as stimulus), and this has to have some impact on the AUD).

    Heck, the AUD could even strengthen for some weird reason.


    • Deus Forex Machina

      I haven’t covered this off yet in my 5 drivers have I? Will have to do that next week but interest rate differentials do play a really important role in FX markets. But you are right the high level of Australian interest rates by developed world standards is a huge incremental positive for the Aussie

      Specifically for the AUD it is a multilayered role but I think the 2 key drivers are that interest rate differentials,
      1) Give offshore fund managers an excuse to buy AUD…we are a very small percentage of the global bond indices and these asset managers need an excuse to go overweight and they do this by allocating money into Australian Government and Semi Debt but it is the capital gain (from a ris in the AUD) that is normally their primary target not just the interest rate pick up but the differential is their excuse to go long Aussie;
      2) It signals the relative strength of the two economies on either side of the cross (eg AUD and USD or AUD and GBP etcetera)and thus the chance of capital gains by being long AUD.

      At the moment the interest rate differential for the Aussie just highlights the domestic story, the China story and the fact that you can actually get a decent earn on when you park your money in Aussie assets while making a capital gain on the “expected” currency appreciation.

      So if the Aust. housing market falls in a hole and the RBA has to cut, or if China missteps at a time where households are under pressure, like the present, then AUD will definately see some selling.
      Equally the differential can close from the other side. For example if the Fed increases rates then attractiveness of AUD assets falls a little, not to mention the game changer this could be for risk assets generally, and the AUD may also come under pressure.

      • Thanks for your insights DFM.

        In regards to your second point of reasoning, I am more inclined to the view that a structural shift occurs over longer periods with real productive enhancements that pushes up the real exchange rate. However the current last 2 year remarkable pull-back would be more in the camp of cyclical commodity trend that Leith has pointed to. Cant get the links now but CRB and AUD have had very strong correlations over longer periods.

        As for the +ve differential, and it being sustained going forward is very questionable! A lot of good news is priced in, with central bank being behind the curve completely discounted! Bernanke is on record with commentary that has now become amusement source for some now! I hope that is not the case with us!

  3. What’s with the weak dollar talk on this site?

    You do understand this is the same dollar you are forced to accept in payment of debt and are supposed to hold your life’s savings in?

    A strong dollar is in the interest of all holders of dollars.

  4. AUD- safe heaven, reserve currency…

    RBA is providing AUD denominated credit to the world, Big4 are not biggest beggars(sorry, borrowers), central banks all over the world are holding their AUD reserves. In any risk off event everyone rushes to buy AUD and OZ gov bonds…:)

    it’s clearly evident how long boom affects thinking of even otherwise perfectly reasonable guys (no offense)

  5. by the way, for every us dollar of total external OZ debt- RBA has 4 cents of usd reserves (920b vs 36b as of beggining of 2010, coverage ratio 0.04).

    basicaly that means that we have sold Australia for illiusion of house “wealth”
    and will have to dig Pilbara dust long enough to cover the difference 🙂
    or print very hard.

    but, no worries, liquidity never dries…
    and debts are never called in or refused to be rolled over (BankWest comes into mind).

    p.s. for comparison:
    NZ: 31c reserves for every dollar of external debt. (coverage ratio 0.31)
    Singapore: 10,78 dollars in reserves for every dollar of debt (more than 10x coverage)