Australian dollar flies on…whatever!

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The Australian dollar “five drivers” valuation model is worth revisiting today given the price action is looking quite bullish. The five drivers are:

  • interest rate differentials;
  • global and Australian growth (more recently this has become more nuanced for the Aussie to be more about Chinese growth);
  • investor sentiment and technicals; and
  • the US dollar

For the first, my view remains that there is still very little chance of local interest rate hikes with falling terms of trade, the capex cliff and a soft labour market likely outweighing the bloom in activity in cyclical sectors. However, the run of decent cyclical data has firmed interest rate market conviction that we’ll see rate rises in the year ahead with 11 bps now priced in (admittedly it’s been going sideways for six months). Bill Evans’ back-flip yesterday added 6 points and immediately pushed the dollar up 20 pips and it hasn’t looked back, though we’ve not yet broken to new highs:

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On the other hand, the rise in US bond yields that many expected this year has so far been cut short by a run of terrible economic data. Weather has largely been blamed and is responsible in some (possibly large) measure. That has meant that the carry spread between Australia and US 10 year bond has risen a little but remains in its recent range:

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The progress of taper at this point is anybody’s guess but assuming the weather is mostly to blame, the economy will snap back quickly and bond yields should rise some more. We saw solid evidence of that last night with the strong rebound in industrial production (chart from CR):

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Industrial production increased 0.6 percent in February after having declined 0.2 percent in January. In February, manufacturing output rose 0.8 percent and nearly reversed its decline of 0.9 percent in January, which resulted, in part, from extreme weather. The gain in factory production in February was the largest since last August. The output of utilities edged down 0.2 percent following a jump of 3.8 percent in January, and the production at mines moved up 0.3 percent. At 101.6 percent of its 2007 average, total industrial production in February was 2.8 percent above its level of a year earlier. The capacity utilization rate for total industry increased in February to 78.8 percent, a rate that is 1.3 percentage points below its long-run (1972–2013) average.

Other data was less promising. The Empire State manufacturing index rose a point to 5.6 and the NAHB confidence index only managed a small bounce back. But IP is the big one so data was taper favourable on the night.

On driver two – global, local and Chinese growth – we face something of a dichotomy. Global growth may accelerate this year but Chinese growth is going to slow over the next six months to 7% and go lower if the rebalancing process is allowed to run its course. Following the economic planning meeting last week and pledge to cut fixed asset investment growth to 17.5% as well as maintain M2 growth rates at 13%, we’ve had poor trade and credit data plus the iron ore crash.

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Yesterday we also got glimpse of the commitment to continue urbanisation. From the FT:

China’s leaders have revealed a plan for a multiyear round of state-led infrastructure construction that they hope will prop up the economy amid flagging growth, as they move 100m more people from the rural hinterland into the country’s growing cities.

The Chinese government’s “National New-type Urbanisation Plan”, revealed on Sunday, envisions a massive building programme of transport networks, urban infrastructure and residential real estate from now until 2020.

…As part of the planned infrastructure construction, the government plans to ensure that every city in China with more than 200,000 residents will be connected by standard rail and express roads by 2020, while every city with more than 500,000 residents will be accessed by high-speed rail.

New airports will be built to ensure that the civil aviation network covers about 90 per cent of China’s population.

The plan also calls for the redevelopment of 4.75m household units in rundown shantytowns this year alone, with an expected total cost of Rmb1tn ($163bn), according to state media reports.

The urbanisation plan appears to be a strategic document and the details are probably not new spending but a refinement of old. China already had a commitment for 7 million new housing units this year. Though I’m guessing, I would not, at this stage, characterise this as new stimulus. Having said that, it’s clearly old-growth oriented and will be be supportive to steel in some measure as well as keep headline growth from slumping too far. In effect it mitigates against “hard landing” scenarios so therefore does support the Australian dollar.

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Australian growth is probably neutral, on balance. All things being equal, I expect another year of sub-par growth, under 3%, as the capex cliff, falling terms of trade and national income outweigh the cyclical forces of monetary and fiscal stimulus.

On the other hand, the US and global economies aught to chug along closer to 3% this year, a little above Australia.

Drivers three and four, technicals and sentiment, are stronger than last week. Sentiment has clearly taken a short term turn for the better with the Bill Evans effect. It’s important to note that Bill’s call was for no hike for 18 months but that’s still supportive to dollar strength given nobody expects Federal Reserve rate hikes until that time frame either. Moreover, Bill’s credibility removes more downside risk of rate cuts, raising expectations for future Australian dollar gains.

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Another possible positive for sentiment is we know that central banks have been adding Aussie to there reserve portfolios for a few years. That has been a significant real support to higher valuations and general market sentiment around the currency. The IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER) report shows the accumulation was still aggressive in early 2013:

IMF

However, it is interesting to note that as the Aussie has regained its cyclical mojo and gotten cheaper, official buying has slowed to a trickle. That does not strike me as especially committed to the cause. Buying in the twin currency in Canada has remain much stronger. That’s not to say we’ll see a reversal in the holdings. But we aren’t seeing much in the way of bargain hunting either. This has not been updated since December.

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Recent international flows into Australian assets show a flat to falling trend for equities and negative but rising trend for bonds (charts from ANZ):

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Nothing decisive but trending towards strength.

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On the other hand, the large and small speculators that control the market remain net short in the Commitment of Traders report:

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On technicals, the Australian dollar also looks firm, with an inverted head and shoulder pattern and room for a decent run if we get a decisive break near 91 cents:

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The final driver, the valuation of the US dollar, is looking weak but perhaps not for long. The turn in US data should come and, just as importantly, expectations for the recovery are suddenly muted:

US economic surprise index

As post-winter data flows, the US dollar should firm with taper expectations. That aught to be Australian dollar negative but right now it’s taking all comers.

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The upshot is that the conditions for Australian dollar look more solid this week than last. My long term view remains unchanged – downside first to 80 cents and then lower still – given I see no sustainable recovery in Australia until its below 80 cents permanently.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.