How high can the Australian dollar go?

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The Australian dollar has hit the afterburners, last night rocketing to 93.6 cents before retracing slightly:

AUD

What’s going on and high will it go? The story is still largely one of carry. With last week’s Chinese stimulus announcement and mediocre US jobs report, markets have settled back into a low volatility paradigm of ongoing Chinese growth and US stimulus. The JPMorgan forex volatility index is at its lowest since 2007! The lack of volatility is not only helping the really high yield emerging market pairs, but also putting a further bid in the AUD, CAD and NZD (or bloc currencies). AUD/USD has broken the 61.8% retracement of the October to January sell-off at 0.9339 and while it is starting to get overbought could be eyeing the November 20 high of 0.9447 over the coming weeks.

As such, the Aussie is not the only one rising. Indeed, anything with a decent interest rate uplift from Japan and US is pouring it on. Brazil:

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BRZ

Korea:

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South Africa:

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SA

To name a few. BNP Parisbas via FTAlphaville sums it up:

We think the underperformance of emerging-market fixed income markets since May 2013, coupled with the sharp sell-off in emerging-market FX in January this year, left most market participants defensively positioned. We also think this is now starting to change. Charts 3 and 4 show that that flows are turning.

EM-flows

While data from EPFR continue to show outflows from emerging-market bond and equity funds, we would point out two things: (1) reported outflows have, in fact, been moderating (Chart 3) and (2) we do not think the data sample is representative of the whole picture. This takes us to Chart 4, which shows that on the whole, the month of March has seen inflows by non-residents into emerging-market bond markets. The exception here is Turkey, but we would point out that Turkish data are reported with a one-week lag, so the figures below may not paint the full picture as yet.

And from Barclays:

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One of the key features in currency markets in recent years has been the significant underperformance of higher yielding, mostly high current account deficit currencies against their lower yielding peers. Figure 1 shows a basket of these EM high yielders (TRY, INR, IDR, BRL and ZAR) against Asian surplus currencies (TWD, KRW and SGD). While most surplus currencies have remained steady against the US dollar in a generally dollar positive backdrop, high-deficit, high-yielding EM currencies have fallen about 30% since the middle of 2011.

This divergence is notable, given how closely most EM currencies traded with each other in the preceding few years. At the macro level, it is clear that a backdrop of deteriorating current account balances, combined with expensive exchange rates and lower yields, made higher-yielding EM currencies an unattractive investment. Lately, there have been signs that current account balances may finally be improving in some of the more vulnerable EM countries. This is certainly true in India, although there are plenty of signs of improvement elsewhere.

…Our attractiveness score for EM high yield currencies is a purposefully simple way to think about how far EM high yield currencies have adjusted to the deterioration in macro fundamentals. Still, the measure does serve as a reminder that a combination of significant FX declines and higher carry makes the case for investment far more appealing than it was just 11 months ago, when Bernanke’s speech on potential tapering kicked off a major dislocation in EM markets.

To be honest, I think Barclays gives markets too much credit. These are largely momentum trades based upon the reassurances of various macro authorities, not economic fundamentals.

They’ll reverse in due course when it becomes apparent once more that the US is speeding up and China is slowing down but first the Aussie is going higher.

How high will depend upon the pace of tapering, the pace of China’s slowing and the erosion of hawkish attitudes in Australia, as well as any shock emanating from Ukraine. My guess is we could run to 95 cents or above by mid year or even a little later as inflation peaks.

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But the US recovery will continue, China will keep slowing towards 7% and then below and the higher dollar will choke off any talk of rate hikes in Australia, setting the scene for its reversal before long.

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.