Australian dollar top is in

On Monday I posted a technical piece saying the the Australian Dollar had hit resistance and so far it appears that the 1.1014 level has proved to be the ceiling that I thought it was going to be. It was tested on two distinctly seperate occasions on Monday Sydney time and then again in New York for 2 hours that night. So technically it looks fairly solid for now. Here’s the chart:

What the piece didn’t do was look at the fundamentals so it was timely when on Monday afternoon I recieved a fundamentally based piece from John Kyriakopoulos who is the Head of Currency Strategy at NAB.

JK reckons that above 1.10 the Aussie is starting to look stretched.

AUD/USD above 1.10 would start to look clearly expensive on medium-term valuation criteria such as the terms of trade or current account balance.

But he is not by any stretch of the imagination bearish. Like your humble blogger, he reckons the underlying support remains solid.

Our long standing view is that the average AUD/USD rate over a full cycle is shifting up to 0.90 from the 0.70 averaged in the twenty years after the floating of the currency in December 1983. This outlook is based on Australia’s terms of trade averaging 50%-60% above the long-term average over the next decade. Above 1.10, AUD/USD is over 20% higher than our estimate of the new long-term average exchange rate. So the cyclical drivers of the currency, such as the wide yield differential, would need to persist and perhaps even widen by more than currently expected, to keep the AUD above 1.10.

Notice where JK has the average, he thinks that it is going to move from the 0.70 to 0.90. I happen to agree that something in this order of magnitude is more likely the result of the positive convergence of economic and investment fundamentals and crucially this is important information that needs to be given to Australian businesses.

This is especially so for two reasons:

  1. It means that levels up around 1.10 won’t likely be sustained indefinately and
  2. Nonetheless, plan for a higher exchange rate through time in your forecasts

JK makes a good point about the relationship between the Aussie and the current account deficict and how these two relate, you might say correlate. He says:

Alternatively, we might be wrong about how high the new long term or equilibrium AUD/USD rate has shifted. One argument in this regard is the very favourable outlook for Australia’s current account balance.

Our long standing view is that Australia’s shrinking current account deficit argues for a re-rating of the AUD and justifies a significant structural appreciation in the currency such that its average over the next decade could be 30% above that averaged in the 20-years after the floating of the AUD in December 1983.

In recent years Australia’s current account deficit has fallen sharply to an estimated 1.2% of GDP in 2011 (NAB forecast) compared to a long-term average of around 4.5% of GDP and 6% of GDP at cycle peaks (including during the previous climb in commodity prices prior to the Global Financial Crisis).

The sharp rise in Australia’s household savings ratio has meant that that a much higher share of Australia’s investment is being funded domestically. Witness the sharp growth in household
deposits. Indeed, household savings has risen by more than 5% of GDP since 2005 (when households were net borrowers). So while higher commodity prices and shipments have boosted export receipts, growth in imports have been relatively modest.

A much lower Australian current account deficit suggests the AUD isn’t overvalued as purchasing power parity would suggest. If the exchange rate was significantly overvalued then Australia would soon be running consistent trade deficits and the current account deficit would widen significantly. If we eyeball a chart of AUD/USD versus the current account balance then to justify +1.10 we’d need to see the current account deficit averaging less than 1% of GDP in coming years. The IMF’s current forecasts are for
Australia’s current account deficit to average closer to 3% over the next five years which is more consistent with 0.90-1.00 as the new equilibrium AUD/USD rate rather than 1.10-1.20.

AUD at +1.10 would overshoot likely fall in current account deficit.

So at its essence JK is saying that the Aussie is at the outer edge of its envelope based on his reading of the fundamental tea leaves.  These are medium term considerations obviously and don’t really help those businesses being buffetted by the current Aussie strength, but they are important in ensuring that businesses don’t panic up here and lock in foward cover. Options are your best bet if you are worried. At least then if JK is wrong and it does drive higher you have cover and if he is right then you still participate in the Aussie’s pullback.

For mine the jury is out on where this long term high will be. $1.1014 is it for the moment but I think a lot of the re-rating for the Aussie and Australia still has to be worked through. I wouldn’t rule out an eventual push higher. Or, more likely, if and when the USD forms a solid base that the Aussie’s strength rotates into the crosses such as the EUR and GBP.

But the key here is that  JK’s fundamental analysis has converged with my technicals analysis to deliver a very strong signal that the top is in for now.

Disclosure: This post is not advice or a recommendation to buy or sell. Do your own research and consult an adviser before allocating capital.

Comments

  1. DFM,

    “Notice where JK has the average, he thinks that it is going to move from the 0.70 to 0.90”

    It might but lets see if this holds true after Australia goes through its GFC that was band aid up in 2008. I am very sceptical on lot of things in Australia right now. Things are starting to not look so good down here. The negative train is moving and if keeps getting momentum and the housing market crashes (which I believe will) dont think they AUD is going be so hot. Big Call to say this is the new average. You could be right.

    • Deus Forex Machina

      You are right to be sceptical. The paradigm shifts more often than non-FX people appreciate.

      It is unfortunate that I can’t be more exact but we will only know the truth or not of this re-rating once the economy slows properly or China mis-steps.

      I’m sure we’ll trade in the 80’s again at some point but its a question of where the average will be. I certainly don’t think it will be up here but I don’t think it will be back at 70 or 74 either.

      In many ways its a cop out to say it but only time will tell. In the meantime companies need to have currencies as a risk factor to their business and insure them as they do their building.

  2. 3 days of red (black) candles on my daily charts and approaching stop loss on my super-short term trading system.

    Your “next 3 cents move is likely to 1.07) seems on the money DFM.

    Risk markets RTW are looking very toppy indeed.

    • Deus Forex Machina

      Hey prince…it satisfied my first target from yesterday’s short term piece this morning but it needs to get down through 1.0775 to accelerate I reckon.

      those three down candles look portentious don’t they…macd about to cross over as well…

  3. Tend to agree LBS.

    Readers might find this 2 year chart interesting (XJO vs AUD/USD):

    http://img714.imageshack.us/img714/981/audusdxjo.png

    Up until around 6 months ago we had the XJO and AUD/USD almost in lockstep, the AUD since blasting away (I imagine in part due to the weak USD).

    If we see house price falls and lower than expected bank profits pull down the financial sector or a dip in commodities as Fed stops expanding their balance sheet end of June then we could see the XJO fall and I imagine it will take the AUD with it.

    Even if .90-1.00 is the new average, we tapped 1.10, no reason IMHO we can’t tap .80 or possibly lower on the downside… I’m far from an FX expert though, this is just in my humble opinion.

    Good article by the way DF. Have been reading your analysis with interest as may be looking to head to the US later this year and have been looking to buy some USD.

    • Deus Forex Machina

      You are right on the volatility implied by your view. It was this, and the challenge that figuring the aud out is, that attracted me to currencies in the first place.

      As per above I agree we’ll see an 80’s handle again

  4. Thanks DFM. I am a ‘small’ importer trying to deal with the big changes in the currency value. Your analysis makes sense and helps me a lot.
    Philosophically I am in the school of thought that thinks this currency should be down somewhere that makes a significant Current Acccount Surplus, pays off some of our debt, buys back some of our sold assets, and sets up some sort of reserve to make up for the fact that what we dig up doesn’t last forever. It’s a notion that I have found makes me often wrong about the actual direction of the A$.

  5. DFM / Other More Learned Minds Than I,

    This is a bit off topic, but do you have thoughts about why the AUD hasn’t experience a large uptick against the JPY like it has against the USD?

    To my (admittedly amateur mind) the Japanese economy looks poorly positioned over the medium term owing to debt levels and their continuing demographic problems (which will only be exacerbated in the next 10 – 20 years).

    Althought the AUD is trending up against the JPY, a quick look at XE over the last year shows a substantially different gradient to the USD.

    Interested in hearing anyones thoughts about AUD medium / long term average against JPY.

    • Deus Forex Machina

      This is an interesting question and a good point…often the crosses between countries are easier to figure out because the drivers are more exact say aud/eur or aud/chf

      but its also important to see which side of the cross is the driver of the cross – that is aud or eur, chf or jpy. it changes throught time and where the overall market is

      the key to this cross is that the Yen is a strange beast in currency land. It tends to have a different set of drivers than other currencies for a couple of reasons.

      1) its been a funding currency for many trades for many years – so when times are good for markets there is plenty of yen selling (effectively boorowing at low interest rates) to then buy a higher yielding ccy like the AUD

      2) there is a large retail market for investment – the famous “Mrs Watanabe” (Japanese Housewives). similar to 1 above. they invest offshore.

      3) then of course the overall investment position of Japan

      what we see is that when things are good the yen is stable to weak but when they turn awry the Yen gets strong becasuse people either exit short yen positions or japanese repartiate their offshore investments

      so a natural aud/jpy trade, which should have been an even faster appreciation of ther aud here then against the usd gets complicated by these “investment fundamentals” considerations
      on a fundamental basis

      usd/jpy should be at 100 or morebased on where the japanese demographics, fiscal position and economy are headed but instead it traded down to 79.60 again tonight.

      this is just too strong given where their economy is at presently and I’d expect the japanese to intervene today.

      that should see aud/jpy bounce as long as the aud’s weakness doesn’t accelerate. We have already seen 1.06 tonight