Australian dollar to 90 cents?

See the latest Australian dollar analysis here:

Macro Afternoon

Via North West Strategy:

After the early surge in the activity post the lifting of initial nationwide lockdowns, the Australian economic growth recovery has been mixed since the resurgence of cases and fresh lockdown in Victoria. However, the COVID situation has now improved in Victoria and case growth has slowed down, setting the stage for a better Q3 outlook.

The country’s ties with China have helped its overall GDP growth in Q2 in comparison to global peers as Australia’s external account held up quite well. Although relations between both countries have soured over the past 3-4 months, we do not expect material escalation in trade tensions. Also the fall in tourism and education exports due to visit restrictions could be a drag in the future. The economic outlook in the short term looks better, though virus trends would eventually be the main game changer in a slightly longer term horizon, with fiscal and monetary policy playing a key role in providing support to the economy.

The RBA continues to maintain an accommodative stance to help the economy and said in its September minutes it is considering further measures to support the economy. We think this could manifest either via a cut in the policy rate (but not to negative) or via tweaks to QE, perhaps as soon as the next meeting. While more dovish RBA policy is a risk to our AUD view, the AUD has strengthened in line with industrial metal prices and China’s recovery. According to or Behavioural Equilibrium Exchange Rate framework (BEER), AUD/USD remains too low by as much by >10% and is currently generating a buy signal for AUD/USD. The AUD is also shown to be cheap against a weighted measure of FEER, REER & PPP deviations. From a trading portfolio perspective, stay long AUD/USD.

Favourable valuations, key drivers supportive |Stay long AUD/USD,

 AUD/USD performance has been driven by Copper prices in the past (10y Rsquared: 74%). Copper prices have risen 30% since mid-April due to both demand side and supply side dynamics. There have been numerous production disruptions in Latam countries due to COVID-19. While the demand side was driven by the Chinese government stockpiling on commodities which had fallen sharply in March. China. China is also reportedly planning to boost vast state commodity reserves in the coming 5 years.

 We expect AUD/USD to continue benefitting from 1) China growth recovery 2) rising Copper prices 3) favourable real yield differentials. Due to Australia’s trade links with China, AUD tends to appreciate versus the dollar in periods of falling China stress (Chart 6). Chinese ongoing growth recovery bodes well for AUD performance. The country recently reported better than expected industrial production, fixed assets investment and retail sales. Retail sales rebounded marginally to 0.5%y/y, in MoM terms retail sales improved by 1.25% m/m suggesting a return of consumer demand.

 In our NWM BEER model, we find that the key drivers are Asian equities relative to US equities, copper prices; Australia/US real 10y yields differentials and VIX index. At present, the model suggests AUD/USD is currently >10% below its long term fairvalue level (0.88) and generates a buy call for AUD/USD. Deviations from fair-value are shown in Chart 9. The rise in the fair-value has been driven by favourable real yields differentials and rising Copper prices.

 In addition to the BEER framework highlighted in this note, the currency also looks cheap on G30 three-factor framework based on FEER, REER & PPP deviations. Stay long AUD/USD

A few points. The AUD may be correlated with copper but its is not driven by it. Australian exports bugger all of the stuff. The correlation is a measure of two things:

  • weak DXY, and
  • monetary inflation of all commodities.

This is an important distinction because the AUD is actually driven by iron ore, coal and LNG and if they were to diverge from copper then so will the AUD. This has already happened to the last two. Iron ore is now the key.

As well, nowhere in the NW analysis is immigration mentioned. Yet COVID-19 uniquely challenges the Australian business model by killing it off. This is certain to be exacerbated by the mushrooming cold war with China. For this reason, we see Australia’s domestic recovery lagging other developed nations.

That is not to say that we see AUD falling straight away. I see iron ore higher through H1, 2021 and it will take time for the global recovery to overtake Australia as well. Moreover, a fearful RBA will lag all other central bank innovation.

So, beyond today’s building correction in risk, I do see the AUD taking off again into 2021. But not so much that it matches fair value models like NWS that see it heading for 90 cents. By mid-2021 the headwinds of topping and falling iron ore plus terrible domestic demand will begin to win out.

BTFD perhaps but not for a long term hold.

David Llewellyn-Smith
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