Special Report – Aussie rally falters, but was it doomed to begin with?
February 7, 2018 4:26 pm
The Australian dollar posted an incredible rally of 8.5% against its US counterpart during early December and late January, fully reversing the September-December downtrend and setting a 2½-year high of $0.8135. However, that rally is now looking in trouble, with the pair declining 3.5% from its January 26 peak and technical indicators turning negative. But even before the uptrend came to a halt, the aussie/dollar’s performance had raised eyebrows among some market participants about the sustainability of such strong gains as many of the factors driving up the pair appeared temporary.
After hitting a 6-month low of $0.7498 on December 8, the aussie turned higher with the help of a year-end rally in commodity prices. The Australian dollar is closely linked to resource commodities such as iron ore, copper and coal, which, along with equities, benefited from the expectations of a continuation of the ‘goldilocks’ economic environment in 2018. A goldilocks economy is one where strong growth is accompanied by low inflation and low borrowing costs.
However, the outlook for commodities demand in 2018 is not as certain as the market rally would suggest given the expected slowdown of the Chinese economy and some concerns about oversupply. Weaker demand from China due to the government’s measures to curb pollution and reduce overcapacity, as well as tighter lending controls could weigh on commodity prices, and therefore the Australian currency.
A weaker US dollar was the other main contributor to the aussie’s recent uptrend, which has been quite puzzling when taking into account the declining yield differential between US and Australian government bonds. Interest rates in the US went up three times in 2017, while they were on hold throughout the year in Australia. The yield spread between 10-year government bonds briefly turned negative on February 2 and looks set to head to negative territory again in the near future as the Federal Reserve continues to raise its benchmark rate over the next 2-3 years, while the Reserve Bank of Australia is not expected to begin increasing rates until late 2018 / early 2019. This would likely pressure the Australian dollar versus the greenback as Aussie yields lose their premium over the US.
The Aussie’s declining yield advantage also highlights the absence of strong fundamentals driving the recent rally. While the Australian economy remains relatively healthy, with growth rebounding from a mild downturn in Q3 2016, inflation remains low and wage pressures have yet to develop despite robust job gains in recent months. This means the RBA can afford to stand pat for some time yet, especially as it remains worried about weak domestic consumption as indicated at its January policy meeting.
But moving into the middle of the year, it’s quite likely the RBA will begin to shift its current neutral stance to a more hawkish one, giving the aussie bulls a reason to re-enter the market. The question is whether the potential boost would be able to outweigh the effects of an anticipated widening negative yield spread with the US. Plus, the RBA will be careful not to sound overly confident in such a scenario out of fear of pushing up the exchange rate.
Several asset managers have already given out bearish predictions about the aussie, forecasting that it would fall towards $0.70 by year end. The 0.70 level seems a long way off from the current near 0.80 rate of aussie/dollar and would mean breaking below its long-term ascending trend line. But should the Chinese economy weaken more than expected and the bullish outlook for commodities does not materialize, big losses look plausible. The Australian government’s own forecasts of iron ore prices in 2018 are substantially lower than that of most market analysts, indicating the optimism about commodity prices isn’t universal and may be a sign of the uncertainty regarding the outlook.
The aussie’s recent gains appear more justified when looking at Australia’s terms of trade, which rose in the fourth quarter. In fact, the terms of trade have been rising more sharply than aussie/dollar since early 2016, suggesting the pair is undervalued. The terms of trade index measures the ratio of export prices to import prices. An increase in the terms of trade is positive on the trade balance as Australian export prices rise faster than import prices.
With the aussie’s performance in the medium-term horizon likely to be influenced by that of the US dollar and commodity prices, the near-term picture is being dictated by risk flows on the back of the equities sell-off. M&A activity also influenced short-term moves as large international acquisitions of Australian companies in December temporarily increased demand for the aussie. With these in mind, the aussie may continue to face some downside pressure over the coming days if not weeks, with $0.78 and $0.7750 being a key support levels to watch. If breached, it could signal a deeper bearish phase for the pair. But even if the aussie avoids a big a down move, it risks an extended period of consolidation without a successful challenge of the $0.81 handle, which it failed to break several times in January.
The Australian dollar posted an incredible rally of 8.5% against its US counterpart during early December and late January, fully reversing the September-December downtrend and setting a 2½-year high of $0.8135. However, that rally is now looking in trouble, with the pair declining 3.5% from its January 26 peak and technical indicators turning negative. But even before the uptrend came to a halt, the aussie/dollar’s performance had raised eyebrows among some market participants about the sustainability of such strong gains as many of the factors driving up the pair appeared temporary.
After hitting a 6-month low of $0.7498 on December 8, the aussie turned higher with the help of a year-end rally in commodity prices. The Australian dollar is closely linked to resource commodities such as iron ore, copper and coal, which, along with equities, benefited from the expectations of a continuation of the ‘goldilocks’ economic environment in 2018. A goldilocks economy is one where strong growth is accompanied by low inflation and low borrowing costs.
However, the outlook for commodities demand in 2018 is not as certain as the market rally would suggest given the expected slowdown of the Chinese economy and some concerns about oversupply. Weaker demand from China due to the government’s measures to curb pollution and reduce overcapacity, as well as tighter lending controls could weigh on commodity prices, and therefore the Australian currency.
A weaker US dollar was the other main contributor to the aussie’s recent uptrend, which has been quite puzzling when taking into account the declining yield differential between US and Australian government bonds. Interest rates in the US went up three times in 2017, while they were on hold throughout the year in Australia. The yield spread between 10-year government bonds briefly turned negative on February 2 and looks set to head to negative territory again in the near future as the Federal Reserve continues to raise its benchmark rate over the next 2-3 years, while the Reserve Bank of Australia is not expected to begin increasing rates until late 2018 / early 2019. This would likely pressure the Australian dollar versus the greenback as Aussie yields lose their premium over the US.
The Aussie’s declining yield advantage also highlights the absence of strong fundamentals driving the recent rally. While the Australian economy remains relatively healthy, with growth rebounding from a mild downturn in Q3 2016, inflation remains low and wage pressures have yet to develop despite robust job gains in recent months. This means the RBA can afford to stand pat for some time yet, especially as it remains worried about weak domestic consumption as indicated at its January policy meeting.
But moving into the middle of the year, it’s quite likely the RBA will begin to shift its current neutral stance to a more hawkish one, giving the aussie bulls a reason to re-enter the market. The question is whether the potential boost would be able to outweigh the effects of an anticipated widening negative yield spread with the US. Plus, the RBA will be careful not to sound overly confident in such a scenario out of fear of pushing up the exchange rate.
Several asset managers have already given out bearish predictions about the aussie, forecasting that it would fall towards $0.70 by year end. The 0.70 level seems a long way off from the current near 0.80 rate of aussie/dollar and would mean breaking below its long-term ascending trend line. But should the Chinese economy weaken more than expected and the bullish outlook for commodities does not materialize, big losses look plausible. The Australian government’s own forecasts of iron ore prices in 2018 are substantially lower than that of most market analysts, indicating the optimism about commodity prices isn’t universal and may be a sign of the uncertainty regarding the outlook.
The aussie’s recent gains appear more justified when looking at Australia’s terms of trade, which rose in the fourth quarter. In fact, the terms of trade have been rising more sharply than aussie/dollar since early 2016, suggesting the pair is undervalued. The terms of trade index measures the ratio of export prices to import prices. An increase in the terms of trade is positive on the trade balance as Australian export prices rise faster than import prices.
With the aussie’s performance in the medium-term horizon likely to be influenced by that of the US dollar and commodity prices, the near-term picture is being dictated by risk flows on the back of the equities sell-off. M&A activity also influenced short-term moves as large international acquisitions of Australian companies in December temporarily increased demand for the aussie. With these in mind, the aussie may continue to face some downside pressure over the coming days if not weeks, with $0.78 and $0.7750 being a key support levels to watch. If breached, it could signal a deeper bearish phase for the pair. But even if the aussie avoids a big a down move, it risks an extended period of consolidation without a successful challenge of the $0.81 handle, which it failed to break several times in January.
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