The Australian Dollar is overvalued

See the latest Australian dollar analysis here:

Macro Morning

Back in May I wrote a piece saying that I thought the Aussie dollar was going to 90 cents. It only got as low as the high 0.95 region on that run before this current bounce to 1.0290 yesterday. I said at the time that I wasn’t sure when it was going to happen and that it was a long term view similar to my call for a crash in 3 year bond rates for clients last year, so I still hold the view the Aussie is going to go substantially lower at some point.

Now in terms of my fundamental point of view I hold an expectation that the economic outlook for the globe is going to be weaker for longer – that is years of growth below what we had become used to as the globe de-levers from all the debt that has been accumulated over the 15 years or so prior to the GFC.

But market positioning, sentiment and technicals are all very much a part of my overall toolkit, not just for the Australian Dollar but also for markets in general. I would argue that a large part of the rally in the Aussie recently has been relief and short covering and that markets in a general sense are trading off short term flows and will get to this longer term imperative of lower and slower growth when it hits them in the face.

Lets face it – short termism and high frequency trading is the new black.

Looking at the next few charts you can see, however, that the combination of sentiment and positioning can combine to produce a rally like we have seen in the Aussie. The first chart below is of the Citibank Economic Surprise Index for the G10 – you can see data is still not too flash really as data is still weakening against expectations in a general sense.

So it’s no surprise that as a bellwether of growth that the Aussie Dollar saw a really strong push to be short from the speculative community to be short.

But currencies are all about relative value trades – that is, how does the outlook for the drivers of one economy and its returns look against the drivers of another economy and its returns. How this meshes together is how you end with your cross rates – whether its a major currency pair or something more obscure like the AUD/HUF (Australian Dollar v Hungarian Florint) rate.

So when Australian data prints better than expectations and then particularly if its better than  offshore then its a signal the Aussie is going to appreciate.

As you can see here on the very right hand side of the chart the Aussie data has improved materially – which then impacts positioning and in doing so the price. Just look at the relationship between the CFTC positions of specualtors and the CFTC data for speculative positions.

Looks like a pretty good correlation to me between economic surprise and traders positions and this then feeds into the price action although with a weaker linkage as you can see in the chart below.

So we can say that the Aussie’s recent strength has been based on a market that got too bearish (my hand is up), positioning that was skewed and data that improved. But what does it look like now?

That’s an interesting question and I saw a piece from the NAB’s Senior Currency Strategist Emma Lawson on Monday suggesting the Aussie is seriously overvalued at the moment. Emma wrote:

Looking ahead, the slower global growth data is likely to be the centre of attention near term, taking the stage from the immediate EU issues. The AUD is likely to remain beholden to this global sentiment. Positioning is lightly short in the AUD, and the AUD is relatively expensive compared to model estimates and recent history. This biases the AUD lower, but does not preclude a spike higher on global liquidity injections. We would see any spike as a sell opportunity.

The cynical amongst you might say this is the usual bob each way but Emma is just reflecting the interplay between the positioning and sentiment I have talked about above and the fundamental outlook that NAB holds for the global economy. You have heard me say it before – indeed we had a discussion to this effect in yesterday’s Macro Morning – but these drivers work in different timeframes.

Emma reckons that the fair value estimate at Monday this week was 0.9410 against a rate at the time of 1.0238 – that’s more than 1 standard variation above “fair value”. With the divergence between the Aussie and normal drivers like commodity prices being attributed by Emma and her NAB colleagues to the demand for AAA assets. Emma says,

There was a large, and growing, divergence between the AUD spot and commodity prices in the month. This is particularly unusual and has been attributed to AAA demand for Australia‟s sovereign debt. The gap may have closed somewhat since the European Summit, and the rally in commodity prices. However, if global growth data proves as soft as markets expect, this sector may again prove to be a negative for the AUD model in July. A rise in global liquidity injection would create the risk of commodities catching up to the AUD.

Indeed echoing the NAB’s view, one of my old colleagues David Croy at the ANZ in New Zealand in a note about the AUD/NZD rate said on commodities and China:

Commodity prices relevant to Australian exports have fallen quite substantially in recent months. The RBA index of commodity prices is down by 4½% in US dollar terms so far in 2012. ANZ’s new proprietary CCI – which uses commodities and weights representative of apparent Chinese
consumption – suggests prices are down by a larger 10½%.

The fundamentals of the globe are likely to overwhelm the spike in Australian data and as Emma Lawson of the NAB concluded, a further rally in the Aussie dollar is ” a sell opportunity”.

I agree with the NAB guys on a longer term structural basis that the global economic outlook will become undeniable in the months ahead and so will further Aussie weakness.

Have a great day.

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 MacroAssociates 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.

Latest posts by _EcoRon_ (see all)

Comments

  1. drsmithyMEMBER

    Lets face it – short termism and high frequency trading is the new black.

    The new black ? I would have thought after over a decade it qualified as the old black. 🙂

  2. On ‘The Business’ (ABC) last night there was a great little ‘snapshot’ of views from a few different economist/investment groups.

    I was surprised that there are still some calling a target price of $1.05, $1.07 etc… Rational seems to be along the lines of: “we’ll be right; China will pick up again and we’ll be booming”.

    Seems to me a very optimistic call.

    Maybe we’re missing something. We’ve had a target of $0.92 since late (around Nov) last year and have just increased it to $0.93 last week.

    ….then again, I’ve only “successfully” (within $0.02) picked the $AUD twice in the past 5 years (12 month forecast)….so maybe they know something we don’t.

    • Deus Forex Machina

      You know it one of those things…I hate forecasting an end point for a month or a quarter because how can i know both the speed of a move and where its going to end up…it has always struck me like the heisenberg principle in physics

      so i focus on the price and where I think it is going and use options with double the time i expect a move to happen to let it happen

      that’s why i have a clear deliniation between my longer term view and my short term tactical and trading views…

      so while i believe the AUD is biased lower in time if you asked me what quarter of next year i wouldn’t have a clue…

      it is a tough game and all power to the guys who can get the quarterly forecasts right a year out

  3. this week was 0.9410 against a rate at the time of 1.0238 – that’s more than 1 standard variation above “fair value”.

    Curious – what’s a standard ‘variation’? I know deviation, but then I’m not sure where stats would come into this other than as a measure of where the trading activity has been focused.

  4. As long as the USD continues to press the print button and the Euro is in the poo, which is the foreseeable future. The “overvaluation” is the new norm.
    Talking about an “Aussie weakness” is fine, but maybe we should look at the USD strength (or weakness)?

  5. What statistical parameters/time frame are you using when you say “that’s more than 1 standard variation above “fair value”. “?

    • Deus Forex Machina

      GG/Karan

      Sorry for late respose as I am out.

      Standard deviation of the model. That is variance Of the spot from the “implied” level of fair value.

        • Deus Forex Machina

          I’m back at the desk now and I can confirm that I made the mistake in the piece above as a typo…and said variation (why I dont know) instead of deviation

          Apologies for the confusion.

  6. Hi DFM, I don’t think you can attrbute it to short covering. A fall to 0.95 and back to test 0.99 would be short covering. I am short AUD and have been for a few months from 1.05. It’s back to basically where it was when commodities were 20% higher.

    You should not underestimate the effect of interest rate differentials. As macro data here has severely surprised on the upside recently, the effect from lower commodity prices has been balanced by the interest rate effect.

    • Deus Forex Machina

      Hi Hi…not disagreeing with that…my point is though that interest rate differentials are in the NAB model so that should be covered in the “fair value estimate” – in fact it is.

      Here is a link from Emma’s paper which is a pic of what drove the AUD appreciation recently.

      http://www.macrobusiness.com.au/wp-content/uploads/2012/07/what-moved-the-aussie.png

      You are dead right some of it is interest rates but most of it is just a swing in their measure of investor sentiment – which of course is getting unwound now.

      Cheers
      Greg