Is the worm turning for the Australian dollar?

There is a cracking story in the Wall Street Journal overnight about the Australian dollar and Caterpillar and their correlation by Stephen Bernard and Vincent Cignarella. In it they say,

The 30-day correlation between Caterpillar stock and the Australian dollar-U.S. dollar exchange rate is currently 0.85, where 0 means there is absolutely no discernable pattern between their movements and 1 means they move in lock-step. The correlation between the pair has surged higher in recent weeks jumping from 0.47 just over two weeks ago, according to data provider CQG.

With that strong correlation, Caterpillar’s recent stock price slide should be concerning for holders of the Aussie. Since reaching a 2012-high in February, Caterpillar stock is down a whopping 26%.

I noted the Caterpillar announcement in one of last week’s Macro Morning reports noting that they said their strategy hadn’t changed but the economic outlook had. Guidance to 2015 that is a big call on structural economic weakness when we are only at the back end of 2012. Here is how the Wall Street Journal summarised it:

the company said it now expects a 2015 annual profit of $12 to $18 a share, down roughly 14% from a previously forecasted $15 to $20 a share. Caterpillar also trimmed $2 billion from its 2015 sales forecast. While it still expects sales between $80 billion and $100 billion, the cuts are a big red flag for the firm and the future of the Australian dollar.

In Macro Investor this week I also talked about the Caterpillar announcement and how important I think it is in a Macro sense for the investment landscape but I was completely unaware of this relationship although when you think about none of us should be surprised given what business Caterpillar is in should we. Bernard and Cignarella again:

Contributing to the guidance cut, Caterpillar cited weaker demand for construction and mining equipment. The firm is a manufacturer of construction and mining equipment, industrial engines, turbines and locomotives–in essence all the essential ingredients of the Australian mining economy.

Australia’s economy, and thus its currency, relies heavily on the health of mining raw materials and selling them to places like China.

Currency traders should pay heed.

But should they?

For months now the Australian dollar, by any conventional valuation metric, has been as much as 10-12 cents over valued yet at every turn, every bearish nuance, it remains steadfastly strong and well supported.

I’m on the record as being one of those who thinks it will re-acquaint itself with the mid 90 cent region. But my take, and why I think fundamentalists are wrong about the Australian dollar, is that they are missing the role that the Australian dollar plays as a bellwether of risk. Caterpillar is an important barometer of the economic backdrop or outlook but the S&P is the weather vane.

The chart above is of the Australian dollar US dollar exchange rate on a weekly basis versus the rate of change on the S&P 500. You can see that the Aussie rallied off its lows with the equity markets back in 2009 and you could argue has been kept up by the equity rally since.

More telling and the real reason the Australian dollar confounds the critics and fundamentalists is this relationship with then outright price of the S&P 500.

The Aussie’s strength is related to global market sentiment – sure the high level of Australian interest rates has been important, sure the mining boom has been important, sure central bank buying has been important but it is all about the globes attitude to risk and the performance of the bellwether of global risk – the S&P 500.

Caterpillar is a warning sign – but it is the S&P that matters.

Twitter: Greg McKenna . He is the Chief Investment Officer of Macro Investor, Australia’s independent investment newsletter covering trades, stocks, property and yield. Click for a free 21 day trial.

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Comments

  1. I hope it is on the way down – preferably to about 70 cents or below. I’ve got friends in a tourism related business and they told me recently it’s never been worse.

    Domestic tourism and manufacturing have been thrashed by the stupidly high dollar and it’s been a bonanza for people buying foreign cars and having trips overseas twice a year – things our economy can well do without. Time for a return to some sensible historical averages.

      • I understand that a lot of people would be in a huge amount of pain with petrol at $2 or so. However in the longer term we’ll all have to get used to higher petrol anyway what with peak oil etc. My own theory is that cars will end up being a luxury item instead of an entitlement.

        My grandfather used to tell me that before the war (WW2) nobody but the rich could afford motoring and then suddenly after the war everybody started getting cheap (government subsidised) cars from our brand new car manufacturers.

      • dumb_non_economist

        Price of petrol on the day and the buying of 4WDs seems to have a good correlation to daily IRs and the buying of RE. Oh, petrol’s cheap today, note to self; must buy a gas guzzling 4wheeler. Oh. IRs a low today, note to self; must get myself a 30yr loan on an IP.

        No thought as to what prices might be tomorrow!

    • I’ve got friends in a tourism related business and they told me recently it’s never been worse.

      thats unfortunate for them, plenty of other people though benefiting from the high AUD and they say its never been better.

  2. I think AUD is high largely due to USD on the other side, and if low USD is giving S&P500 a push up, then I don’t expect our high AUD to do any favour for ASX200.

  3. Greg…if you have the time and the notion. The correlation with Caterpillar is interesting however I’m a bit worried about its significance.
    Two weeks ago the correlation was 0.47 and now in just the two weeks it is 0.85. This would indicate the data they are correlating is very short term and has been chosen at a time and place to suit their argument. Minor point perhaps!

    That said your warnings should be taken on board by the whole damned country!

    • My view too. I think someone with little better to do runs through the stock charts looking for a correlation then hey presto! Probably the mail room guy looking for a promotion.

      When you get one that correlates at 90% relaibility for 20 years I’ll be all ears.