The Aussie and trade data

See the latest Australian dollar analysis here:

Macro Afternoon

As you know,  your currency blogger reckons that on any time frame you can group the key drivers of the AUD into 5 categories or drivers. The difference is that depending on the time frame being looking at you need to change the subjective weighting you give each set of variables. Technicals are much more important in the short term because price action is essentially “noise” and these tools give the best signposts often. In the longer run macro factors predominate while in between its a mixture of the lot.

But some of the key inputs that sit underneath each of the key drivers don’t work as well as they used to. It’s one of the conundrums of investing and trading that tools that were robust and profitable don’t seem to work as well anymore but it is important nonetheless to understand why these “old tools” have lost some of their predictive power.

Writing in this week’s ANZ Economics Weekly Ivan Colhoun, Head of Australian Economics and Property Research and one of the best Bank Economists in the country, poses the question “WHY DOESN’T THE AUSSIE DOLLAR REACT TO TRADE DATA ANY MORE?” Ivan says:

In days gone by, the current account and trade data were major market moving numbers with 1+ cent moves in the AUD not uncommon. This week’s quarterly balance of payments and monthly trade data passed with negligible impact on the AUD. What’s changed?

Let’s look at what we mean by trade data firstly because in my experience it is an easily misunderstood concept. Ivan says:

Our first chart considers the trends in the main components of the current account deficit. The trade balance has experienced a dramatic improvement in recent years, with a near 5ppt of GDP improvement since the previous low points in 2004 and 2008. The net income and transfers balance over the same period has been broadly stable.

Figures 2 and 3 examine the source of the dramatic improvement in the trade balance. Clearly but unsurprisingly, we identify the surge in the terms of trade (principally driven by Australian commodity prices) as the dominant influence, as export volume increases have been exceeded by import volume growth over the period, though from 2007-08, volume growth has been relatively equal.

Clearly the trade data has been a spectacular boon to the Australian economy but Ivan ask’s and answers the question:

So why doesn’t the currency market react to all this (good) trade news and what implications can be drawn? A few possibilities are:

  • In general, speculative transactions and capital flows now dominate transaction-based foreign exchange flows in currency markets. As such the trade data may just be of little significance relative to the size of other AUD flows. While possible, this explanation seems unlikely as significant data surprises should still lead to further speculative transactions;
  • In the past, the AUD reacted significantly to trade data, particularly when the Australian terms of trade was falling and the current account and trade balance were deteriorating. Then a lower currency was a reasonable market reaction as this acted to encourage export activity and import substitution to improve the situation. At the present time, however, a still higher AUD is not an especially logical reaction from an economic adjustment perspective if – as is likely – the current exceptionally high level of the terms of trade is not sustained in the long term.
  • Most likely, the lack of reaction reflects the fact that the AUD has already priced in the substantial rise in the terms of trade and commodity prices that has been occurring since 2004 (interrupted temporarily by the GFC). The trade balance outcome is therefore not providing any new information to the market. It is likely, however, that the steady stream of net AUD purchasing by exporters reflected in the high trade balance is a source of support for the AUD. In recent weeks, pullbacks in the AUD have been well supported by significant exporter orders below parity.

As such, the markets’ focus in determining the short and medium-term course of the AUD should be on the predominant factors that impact on Australia’s terms of trade and commodity prices (as well as any change in the general trend for the USD, which has long been inversely correlated with the AUD). Chief among these would be developments in global and Chinese growth/commodity demand, while from a medium-term perspective, the supply-side response of major Australian commodities will also be critically important to take a view on.

Ivan has got it right with everything he is saying here and perhaps this is why the AUD curiously sits so close to its recent high but go no higher. Why does the AUD not react to trade data anymore? It’s not because the trade data isn’t important but rather that the trend is assimilated and the individual data releases are subsumed in the myriad of inputs people use when deciding to buy or sell the Aussie and overwhelmed by short term factors on any given release day.

Structurally however  Ivan reckons that the next big move might be for a fall in the terms of trade:

The forecasts of our commodities research team suggest the current tightness in the coal and iron ore markets will begin to ease in 2013 and that commodity prices – and therefore the terms of trade – will begin to decline from later in 2011.

My guess is that if he’s right the Aussie will react to the trade data. At least the change in trend anyway.

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