Is the Australian dollar carry trade back?

Via Damien Boey at Credit Suisse:

As bonds have rallied furiously in recent weeks, an interesting development to note is that Australian real yields have remained flat, while US real yields have fallen sharply to negative from positive. As a result, the Australian-US real 10-year bond yield differential has closed to -0.1% from -0.4% in late July. The real yield differential has improved in Australia’s favour, supporting the AUD/USD.

It is easy to miss this development because nominal Australian-US bond yield differentials are still deeply negative. Australian 10-year bond yields have fallen to 0.87% from 1.19% in August to date, while US 10-year bond yields have fallen to 1.46% from 2.01%. The nominal yield differential has moved in Australia’s favour, but the level remains at -60bps.

For the purposes of currency valuation, real yield differentials, rather than nominal yield differentials matter. Recall that purchasing power parity requires the currency of the country with the higher expected inflation rate to depreciate. But real interest rate parity requires the currency of the country with the higher real interest rate to appreciate (at least initially). So the response of currency to bond yield movements can be very different depending on what is driving bond yields to begin with. With this in mind, the narrowing of Australian-US real yield differentials is quite a significant development. By definition, every 1% movement in real 10-year bond yield differentials should correspond to a 10% movement in the real exchange rate. So the 30bps movement in the differential in favour of Australia raises fair value by 3%.

At the same time, we have seen some commodity prices fall (notably iron ore), but others rise (notably gold). Terms of trade movements have exerted a moderate drag on fair value. But the net balance of real interest rate and commodity price movements has actually been supportive of the currency of late. Indeed, the “joint parity” equilibrium level of the currency has moved to 70c in recent times, while the currency has depreciated to 67c. The AUD/USD is trading at a 4% discount.

The USD/AUD is not the only thing looking expensive. Bonds are also now extremely overbought, if not expensive. Term risk premia globally are deeply negative (ie bond yields are meaningfully below market estimates of long-term neutral interest rates). In Australia, to justify current bond yields, one needs to believe that roughly half of every RBA rate cut from here will be passed on to end borrowers by the banks, even though recently, pass through has been more like 80%, and low interbank spreads are consistent with pass through of close to 100%.

With bonds now looking quite rich and the AUD/USD becoming undervalued, we are entering into a very unique regime. History tells us that when bond yields rise and the AUD/USD strengthens, we tend to see resources stocks outperform, while bond proxies and high quality industrials tend to underperform. Financials experience mixed results.

Except history can prove to be a false analogy. Bond yields rise when reflation takes hold. We sure aren’t here yet.

Especially not in Australia, also from Mr Boey:

The 2Q private sector capex release was slightly disappointing. Private capex fell by 0.5% in 2Q, against expectations for an 0.4% increase. Even upward revisions to prior quarters’ data could not bring the net figure in line with Consensus.

As expected, structures investment fell, consistent with yesterday’s construction work done report. But business investment in machinery and equipment rose by 2.5% over the quarter.

Another piece of good news is that FY20 capex forecasts were revised higher. The so-called 3rd estimate of capex was 10.7% higher than the same estimate from last year, and 14.9% stronger than the 2nd estimate for this year.

Unfortunately, the road to 2Q and 3Q GDP is not paved with good intentions, and so the upgrades to future capex spending estimates do not count near term. Moreover, growth in machinery and equipment capex barely moves the needle for our 2Q “now-cast”, because the expenditure component has a relatively small weight in the GDP calculation. As it stands, with more than 50% of the 2Q partials now “in”, GDP growth looks slightly negative, somewhere in between -0.2 to -0.3% for the quarter. The range reflects uncertainty with respect to how much we can extrapolate retail spending trends to the overall consumption basket, as technically retail sales represent 65% of consumption, which in turn represents 60% of GDP.

What might save the 2Q GDP number from actually printing negative is a strong showing from government spending, or re-stocking activity. But even under optimistic projections, GDP growth is likely to fall well short of the 0.8% nowcast by the RBA.

Should 2Q core (ie non-mining) domestic demand shrink or flatten out as the partial indicators suggest, year-ended activity growth will slow to 1-1.3% from 2.1%. Activity growth will evolve broadly in line with our proprietary activity tracker. The trouble is that the activity tracker leads activity growth by up to a quarter, and is still in slightly negative territory. Therefore, the risk of a poor 3Q print is material. The earliest that we can hope for recovery in growth momentum is 4Q, and even this could be in doubt, pending global developments.

All of this said, we are more optimistic longer term. We expect growth to return to a healthy pace by mid-2020, as nominal easing from the terms of trade boost kicks in. This could either take the form of recovery in mining capex, or more fiscal stimulus. And as we wait, there are also positive signs that credit creation is starting to pick up, because the housing drag is turning around (at least in a demand and prices sense). Further still, the RBA remains on track to cut further.

The likely trajectory for economic growth is very tricky for investors to play. We are likely to see a slow inflection upwards, with wide uncertainty bands from global developments. Short-term, the temptation is to continue chasing defensive assets and stocks until we see evidence of upward inflection, or reduction of uncertainty. But longer-term, it is clear to us that uncertainty will be dealt with globally either through de-escalation of trade conflict, or bazooka options from the Fed and Treasury (eg outright foreign exchange intervention, deep rate cuts, balance sheet expansion). It is also likely in our view that easier financial conditions in Australia will start to filter through to the broader economy, with the fiscal stimulus card very much “live”. And this is before we even consider what capital outflow from Hong Kong could do for the property market, and how the effects of capital flows might be exaggerated by monetary easing, which in turn is being exaggerated by high uncertainty.

Longer-term, we favour curve steepening trades. Within equities, curve steepening supports value exposures, even as lower rates support quality. The issue is that multiple dispersion is now so wide that even if we care much less about value than we do about quality, long baskets still end up containing a lot of value, while short baskets still end up containing a lot of expensive momentum and defensive names. We are not particularly fussed about timing either, because it is worthwhile paying up for diversification when intra-portfolio correlations rise the way they have.

Obviously at some point we’ll see the a pivot to reflation but with Brexit, the trade war and Hong Kong still intensifying it’s not here yet.

On the contrary.

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