How far can the reflation rally carry the Australian dollar?

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DXY was a bit stronger last night as EUR fell:

The Australian dollar didn’t care, bid higher versus DMs:

And EMs:

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Gold was soft:

Oil too:

Metals were better:

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And big miners:

Plus EM stocks:

Junk spoiled the party:

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As Treasuries were sold:

And bunds:

Aussie bonds followed:

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Stocks still looked poised for breakout:

Westpac has the wrap:

Event Wrap

US President Trump stated that the “trade deal with China is coming along great”. This followed positive comments from other Administration officials with respect to the negotiations and potential for Phase 1 of the negotiations to be signed at the APEC Conference in Chile in November.

Brexit: UK Speaker of the House, John Bercow, declared that the Johnson Government could not table a motion to debate another “Meaningful Vote” on the revised Withdrawal Agreement negotiated with EU. This is a strict interpretation of Parliamentary (that a motion cannot be tabled more than once in the same Parliamentary session without material change). As such it delays the process of Brexit once again and will mean that a more cumbersome process of submitting the Withdrawal Agreement Bill will be initiated tomorrow. This frustrates the Government’s plans to obtain a fast track even though they still hope to complete the Commons stage by end of Oct 24th, and the WAB will be prone to a rash of amendments that may further delay or even distort the bill.

Event Outlook

US: Sep existing home sales are expected to decline 0.7%. Gains in previous months have seen sales return to mid-2018 levels, having rebounded by around 10% from the end-2018 trough.

Lots of positive trade scuttlebutt but nothing convincing.

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So, how far does this reflation rally get? On yields, Westpac has some useful thoughts:

There were two important contributions to the RBA policy debate last week. The first was the Minutes of the October Board meeting and the second were some comments by RBA Governor Lowe in Washington.

The Minutes recorded a discussion about the policy stimulus perhaps being less effective than previously and noted the negative effects of low interest rates on the income and confidence of savers may be more significant than was previously the case. As our Chief Economist Bill Evans suggests, that discussion is highly relevant for any discussion around the Effective Lower Bound (ELB) for the cash rate in this cycle.

Later in the week, Dr Lowe was quoted as saying “negative interest rates are extraordinarily unlikely in my country”. That should go a long way to cementing the view that that the ELB is well above zero and gives us confidence in our own view that a 0.5% cash rate will represent the cycle low, albeit with risks of 0.25%.

Certainly no lower.

While there is around 5bp of a November rate cut still factored in, we think that even overstates the probability of that outcome. Beyond that, current pricing shows that our 0.5% forecast is also the market’s terminal rate. So the debate is one of timing more so than degree.

Even so, we see greater risk that the market moves back to pricing a terminal rate lower than 0.5% but no lower than 0.25% before it looked to take the terminal rate back toward the prevailing 0.75% cash rate. Under that scenario we see AU bonds as a “buy the dip” proposition. Further we believe that we are near the bottom of the tactical range, and historical analysis suggests that at 25bp above the terminal rate 3yr bonds will be well supported.

Australian bonds have been trading heavily over the past week or so, with 10yr yields rising to their highest levels since mid-September (1.14%). At that time, with the cash rate 25bp higher than it currently is, they were unable to move above 1.2%, which proved to be strong resistance. We think that will again be the case. In addition, the AU 3-10yr bond curve has steepened to levels last since in early August. There have been a number of drivers of the curve performance. First, with the market exploring the cash rate’s ELB, there has been a periodic bull steepening impulse. Second, the bearish outright correction has been associated with a paring back of these cash expectations, but the latter are still relatively anchored, hence a bear steepening impetus has been in place. That has been further influenced by, third, a shift steeper in the US 2-10yr bond curve (chart at left). The relationship between the AU & US curves is clearly very strong, although the AU curve has been steepening at a slower rate than the US in recent weeks. That is evidenced by the flattening of the AU-US curve box (rhs). The chart also shows the relationship with outright US 10yr direction. If the bearish correction were to slow and consolidate near current levels, as we expect then it should allow the AU curve to peak around current levels. As we noted in last week’s analysis, the 40bp a large resistance level for the AU 3- 10yr futures spread.

We are waiting for higher rates yet before getting longer bonds again. That suggests the AUD has further room to run as well given the scope for a little more US easing this year before the RBA returns with the chainsaw early next.

On the other key driver of AUD value, Australia’s terms of trade, I don’t expect (though certainly see the risk of) lower bulk commodity prices in the next few months. More certain is that that they will fall heavily by Q2, 2020. That’s another time frame for any AUD rally to reverse.

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If it does not happen beforehand owing to trade war volatility.

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.