Australian Dollar Rises Despite Unwinding of Carry Trade

When two weeks ago the Royal Bank of Australia (RBA) cut interest rates, one would have expected the Australian Dollar to suffer proportionately. Instead, the currency continued its steady upward rise, and touched a six-month high, before falling back slightly. One surprised analyst lamented, “These types of inconsistencies can make trading forex difficult or down right frustrating at times.”
The interest rate cut marked the sixth since September, since which point the RBA has trimmed its benchmark lending rate by 425 basis points, leaving it at 3%. [See chart below courtesy of "The Fundamental Analyst."] Traders have reacted to the successive declines in yield and simultaneous pickup in risk aversion by unwinding carry trades, many of which had been long the Australian Dollar. The massive sell-off that ensued left the Aussie a long way below the level of parity with the USD, which only last year many analysts had viewed as inevitable.

The most recent rate cut, in contrast, was greeted positively by traders, perhaps because they were expecting a larger (50 basis point) rate cut, but more likely because their priorities had changed. A pickup in risk aversion in recent weeks has definitely reinvigorated interest in comparatively risky currencies such as the Australian Dollar. Overall, the markets remain risk-averse, and investors are increasingly making bets in accordance with economic fundamentals, rather than yield levels. ” ‘The focus will remain on the global backdrop…Risk appetite is still fragile and the market is increasingly realizing that the recent recovery was excessive.’ ”
In the case of the Australian Dollar, traders were heartened by the RBA’s decision to lower interest rates to a 49-year low since it reflected the Bank’s commitment to dealing with the economic crisis. But at this point, the Australian economy is still in poor shape. “Prime Minister Kevin Rudd said yesterday for the first time that a recession in Australia is inevitable amid a slump in global growth that is eroding demand for natural resources from the world’s biggest shipper of coal and iron ore.”
Meanwhile, “The global economic downturn has pushed Australia’s economy into its first recession since 1991, Reserve Bank of Australia Governor Glen Stevens said.” According to the minutes from the RBA’s last meeting, “Conditions in the labor market continued to soften” and “Further falls in employment and rises in unemployment were expected.” These observations should be viewed in the context of a 5.7% unemployment rate.
The near-term prognosis for the Australian economy remains quite poor, regardless of whether a recovery materializes in 2010, as forecast by economists. Accordingly, analysts expect the RBA to lower its benchmark interest rate further, probably to 2.25% or 2.5%; there is a “bias toward further modest rate cuts, although we continue to think that the RBA may well pause for a few months to assess the impact of the current round of fiscal stimulus,” offered one forecaster.
Given the lull in market activity, some commentators have turned to technical analysis. “Westpac Currency strategist Robert Rennie said their own risk measurement models are clearly flagging a bumpy period ahead for high yielding currencies. ‘Our proprietary models are…clearly telling us to watch risk sentiment and data much more closely than we have over the past six weeks.’ ” In short, traders should not become complacent as result of the Aussie’s recent rally, and should continue to monitor economic data for signs of progress and/or hiccups on the road to recovery.

Australian, New Zealand Currencies Benefit from Risk Aversion

Against each other, the New Zealand Kiwi and Australian Dollar have traded in a pretty tight range for the last year (except for a “blip” in the fall of 2008). This makes sense, as both currencies rise and fall in accordance with exports and interest rates.

Against other currencies, meanwhile, both have torn upwards in the last couple months. Despite steep interest rate cuts, both currencies have maintained their interest rate advantages against other industrialized currencies. This has not gone unnoticed, and the return of the carry trade has been kind. “The current improvement in sentiment is providing an underpinning of support and while that remains the case – and that may be until midyear – the New Zealand dollar is going to remain well-supported,” said one economist.
The correlation between the New Zealand Kiwi, specifically, with the US stock market has become remarkably cut-and-dried of late, which you can see from the chart below. For carry traders, therefore, it probably makes more sense to follow stock market commentary than to track New Zealand economic data. The same economist, for example, warned “that the equities rally, which has seen the broad U.S. Standard & Poor’s 500 index climb 36% from its March low after rising another 3.4% Monday to its highest since Jan. 8, may be dissipating.”

Besides, given the deteriorating economics in both countries, lower interest rates are probably inevitable: “We think this case for further cuts will be made in the second half of this year…we think it will be very difficult, no matter what the global economy is doing, for the RBA to ignore rapidly rising unemployment,” offered one analyst who predicted that rates would be cut to a “trough of 2%.” In such a scenario, the interest rate spread would still remain healthy, but perhaps not enough to offset the additional risk.

Australian home prices are falling at a rapid clip, the labor market is sagging. In New Zealand, meanwhile, a decline in sentiment and consumer spending has corresponded with a 1% contraction in GDP in the quarter ended March 31. Tourism is down, although net exports are increasing. The current account deficit continues to expand, but this is mostly a product of an investment balance – perhaps related to the carry trade.

For now, forex traders remain optimistic, albeit slightly less so than before: “The difference in the number of wagers by hedge funds and other large speculators on an advance in the Australian dollar compared with those on a drop — so-called net longs — was 16,692 on April 28, compared with net longs of 17,250 a week earlier.”

Outlook is Positive for Australia, but Less so for Australian Dollar

The economic outlook continues to improve for Australia. Most recently, both the government and the Central Bank released five-year growth forecasts, both of which show a modest recovery in 2010. “By 2011-12, the commodity-rich economy will again be firing on all cylinders with growth of 4.5%, well above the long-term growth rate of around 3%.”
This positive development coincided with the release of similarly upbeat economic data: “Retail sales surged 2.2 percent in March from the previous month, four times as much as economists forecast. Home-loan approvals jumped 4.9 percent, the sixth consecutive gain.” Meanwhile, unemployment shrank for the first time in months, and consumer confidence is once again rising. While the economy is forecast to shrink by .75% in the current fiscal year, this compares favorably with other industrialized countries.
The sudden turnaround can be attributed to a couple factors. First of all, the pickup in China’s economy is stimulating demand for natural resources, which had been slack for the last year. If not for simultaneously falling commodity prices, Australia might have even achieved positive economic growth for the year.
The government’s stimulus plan and spending initiatives have also played a role, although the extent cannot be measured accurately for a few months. “The government claims that measures in its budget will inject a further A$8.8 billion into the economy in 2009-10, adding to around A$50 billion in fiscal measures already announced since October 2008.”
The outlook for the Australian Dollar, meanwhile, is not so rosy. The 425 basis points in cumulative rate cuts that the Royal Bank of Australia (RBA) effected over the last year have lowered the interest rate differential with other industrialized countries. While the RBA has indicated that it will pause before cutting rates further, interest rate futures reflect the expectation that rates will be lower twelve months from now. “Economists say the RBA is open to cutting interest rates again if consumer and business confidence appear threatened, but for now it is content to let monetary and fiscal stimulus measures take hold.”
To be sure, the uptick in risk tolerance has been good for the Australian Dollar, igniting a 25% rise since March. The currency now stands at a 7-month high against the US Dollar. But the increasingly modest differential is now causing some analysts to question whether it is a reasonable risk to take, especially against the backdrop of volatility and a high correlation with global stock prices. “What’s the point of picking up a 3 percent interest-rate differential by being long Aussie and short Japan in a world where the exchange rate can move by that much in two days?” Asks One analyst rhetorically.
This same analyst is actually recommending investors to use the Australian Dollar as a funding currency, and go long on higher-yielding currencies, such as the Brazilian Real. This particular trade would have netted a respectable 5.9% return in 2009. How quickly the roles have reversed!

New Zealand Dollar Rise Threatens Economic Recovery

Having risen nearly 30% against the US Dollar since March, the New Zealand Dollar (NZD or Kiwi) is now close to a 9 1/2 month high. While still far from the record highs of 2008, the currency is already erased a large portion of the losses it racked up since the credit crisis gave way to economic recession.
As part of last Friday’s coverage of the Japanese Yen, we included a chart which compared the performance of the AUD/JPY cross to the S&P 500. Even without calculating the correlation coefficient, a cursory review of the chart revealed an uncanny relationship! Unsurprisingly, it turns out the same relationship also applies to the New Zealand Dollar, whose recent performance closely mirrors US equities.

In other words, the interplay between risk appetite and risk aversion continues to dominate the forex markets, as traders move to calibrate the split of funds between so-called safe haven currencies and the riskier alternatives, among which the New Zealand Dollar is certainly counted. Much of the rally in the Kiwi, then, represents a correction, as investors acknowledge that the near 50% slide from-peak-to-trough was an overreaction.
Going forward, however, the Kiwi will have to rest on its own feet, as new themes move to the fore of investors’ minds. Specifically, they will begin to look more closely at the New Zealand economy, and demand evidence of a recovery. “Reserve Bank of New Zealand Governor Alan Bollard told a business audience the world has ‘avoided a repeat of the Great Depression. Now, we and the world, appear to be on our way to recovery. New Zealand looks likely to start recovering ahead of the pack.’ ”
At the same time, the most recent economic data showed an economy in freefall, as “New Zealand’s economy shrank for a fifth straight quarter…The economy contracted 2.7 per cent in the January-March quarter.” While forecasts vary, GDP is expected to fall by at least 2.1% in 2009, with a modest pickup expected in 2010. Investors are betting that the recovery will be driven by rising demand for commodities, which will help to buoy New Zealand exports. Once again, this conflicts with the data, which shows an annualized trade deficit of $3 Billion. Despite a fall in imports, the country is still importing more than its exporting. This could be a product of the stronger currency, which all stakeholders agree is not conducive to economic growth. In the end, the economy’s best chance for recovery lies in a resumption of debt-induced consumption and residential construction, the very forces which caused the current downturn. Says Mr. Bollard, “Reliance on past experience of strong house price inflation and easy credit will be untenable.”
Given the uncertain prospects for growth, combined with moderating price inflation, the RBNZ can be expected to hold interest rates at current levels for the near-term. “Bollard will leave the benchmark interest rate unchanged at a record low 2.5 percent on July 30, according to all 10 economists surveyed by Bloomberg.” Based on swap rates, the markets feel similarly, and are pricing a mere 25 basis point hike over the next twelve months. With such a dubious prognosis, one has to wonder whether the Kiwi’s rally is really sustainable.

Reserve Bank of Australia Could be the First to Hike Rates

Based on the chart below, which plots the Australian Dollar against the New Zealand Dollar over the last two years, one might be tempted to conclude that the two currencies are identical for all intents and purposes. Rather than suffer the inconvenience of separately analyzing the Australian Dollar, why not just read yesterday’s post on the New Zealand Dollar, and leave it at that?

But this chart belies the fact that while the two currencies, have risen and fallen (in near lockstep) in sync with the ebb and flow of risk aversion, this could soon change. While the near-term prospects for the New Zealand economy are dubious, sentiment towards the Australian economy is more consistently optimistic.  “Central bank Governor Glenn Stevens said the nation’s economic downturn may not be ‘one of the more serious’ of the post-World War II era.” In addition, “Stevens said the nation’s economy may rebound faster than the central bank had predicted six months ago on improving confidence among consumers and businesses alike.” The latest projections are for a fall in .5% contraction in GDP in 2009 followed by a 1% rise in 2010.

Meanwhile, government spending is surging: “The Australian government forecast its largest budget deficit on record of A$57.6 billion for fiscal year 2009-10, or 4.9% of GDP.” Combined with the steady recovery in commodity prices and the resumption of residential construction, this could soon trickle down through the Australian economy in the form of inflation. It’s no wonder, then, that the Reserve Bank of Australia (RBA) could begin tightening interest rates as early as December, in order to mitigate against the possibility of inflation in 2011 and 2012.

In fact, Governor Glen Stevens has been raising eyebrows with his unequivocal comments about raising rates. “I’ve never seen written down … I’ve never heard in discussion in the institution, some rule of thumb that says we wait until unemployment’s peaked before we lift the cash rate…I think it depends what else is happening, and also depends how low you went. We eased very aggressively,” he said recently. As a result, traders are betting that rates will be 1.13% higher one year from now than they are today.

This development should be of especial interest to forex traders. Australian interest rates are already the highest in the industrialized world. When you consider “the market’s expectations that the RBA is likely to be the G-10 central bank which is likely to hike first,” it goes a long way towards explaining the 18% rise in the Aussie that has taken place in 2009 alone. Compare a hypothetical 4% RBA benchmark rate to the .1% in Japan and ~0% in the US, and carry traders will start to salivate.

Canadian Dollar Slated to Outperform Other Commodity Currencies

In the same vein as Monday’s and Tuesday’s posts (covering the New Zealand Dollar and Australian Dollar, respectively), I’d like to use today’s post to look at another commodity currency – the Canadian Dollar. The Loonie, it turns out, has also benefited from the a recovery in risk appetite and concomitant boom in commodity prices; it has appreciated by 7% against the USD in the last month alone, en route to a ten-month high. “All in all, with almost everything going its way these days (besides the crummy weather and the impact on tourism), a return trip to parity – last visited nearly one year ago – doesn’t seem far fetched,” chimes one optimistic analyst.

Like Australia and New Zealand, Canada’s economic fate is tied closely to commodity prices. Simply, as oil and other natural resources have inched closer to last year’s record highs, the Loonie has rebounded proportionately. “Raw materials account for more than 50 percent of Canada’s export revenue. Crude is the nation’s largest export.” Of course, this relationship works both ways. Any indication that the global economic recovery is stalling, and commodities prices would likely tumble, bringing commodity currencies down likewise.
Unlike the Australian Dollar and New Zealand Dollar, the Loonie has never really held much appeal as a carry trade currency. Even at their peak, Canadian interest rates were mediocre, from the standpoint of yield. The current rate is a measly .25%, compared to 2.5% in New Zealand and 3% in Australia. Moreover, while Australia may begin tightening as soon as the fall, “The Bank of Canada committed to keep its key policy rate at the lowest possible level until the spring of 2010,” after voting to hold rates at yesterday’s rate setting meeting. This interest differential could explain why the Aussie has outpaced the Loonie of late.

Another key difference – and potential explanation for the currencies’ recent divergence – is that Australia is considered part of the Asian economic zone, while Canada’s economic fortunes are closely aligned with those of its main trading partner, the US. China, alone, is helping to lift Australia out of recession. The US, meanwhile, is still struggling to find its feet. Hence, it is projected that Canadian GDP will contract by 2.3% in 2009, while Australian GDP may fall by a modest .5%. “When things look bad, you are more likely to sell Canada than the Australian dollar because its economy is moderated by Asian growth,” explains one analyst.
Going forward, this regional differentiation could actually work to the advantage of Canada, which is forecast to grow by an impressive 3% in 2010, compared to 1% growth in Australia. Accordingly, one analyst advises that “Investors should sell Australia’s dollar against Canada’s as a ‘relative commodity play’ because an attempt by China to reign in bank lending on concern it may be creating asset-price bubbles could slow Asian growth…’The Canadian dollar should outperform because it is much more closely linked to a recovery in the U.S.’ “

Australian Dollar Rises, Remains Closely Correlated with Stocks

The performance of the Australian Dollar over the last six months has been nothing short of incredible: “Since the end of February, the Australian dollar has risen 29% against the U.S. currency,” and a still-impressive 18% if you backtrack to January, when the Aussie was still in free-fall.

As has been the trend in forex markets of late, the currency’s rise cannot be attributed to an improvement in fundamentals. The economic picture remains nuanced (that is putting a positive spin on it), and definitive proof of recovery has yet to emerge. “We really are trawling pretty deep to try and get any snippet of information that might have some backhanded relevance as far as Australia goes,” said one analyst.
As a result, fundamental analysts have been forced to wait for a “more precise picture about the timing [of] any Reserve Bank of Australia interest rate hike.” On this front, investors are ratcheting down their expectations of a rate hike anytime soon, as “The RBA has signaled that there’s a danger of raising rates too soon.” Futures prices reflect the expectation that rates will rise by only 37 basis points from current levels before 2010, and by 161 basis points 12 months from now.
With such economic uncertainty, investors have turned their attention elsewhere. “Nomura Chief economist Stephen Roberts said in the absence of any clues about the fundamental drivers of the currency, nearly all the cues in foreign exchange markets are being taken from equities.” Some analysts have posited a close relationship with the US stock market: “The correlation between the Aussie dollar and U.S. equity market in particular has been very strong over the past few weeks, with our analysis showing a correlation as high as 95 percent.”
For other analysts, the relationship is with the Chinese stock market. This correlation makes more sense logically, since the Australian economic recovery is largely contingent on continued growth in China and the concomitant purchases of Australian commodities. “Currency markets will be watching the Shanghai share market, which has been a pretty big influence on the Aussie recently,” summarized one analyst. A reporter for the WSJ tried to spell it out even more clearly in an article entitled, “Australian Dollar Up Late, Closely Tied To Chinese Stocks.”
Unfortunately, the correlation with (Chinese) stocks runs both ways. When the Chinese stock market tanks – often for inexplicable reasons – as it has for the last three weeks, the Australian Dollar follows suit. Another analyst is more blunt: “The story for the Australian dollar and other risk- and growth-oriented currencies is similar to the share markets. They’ve had a great run and are probably due a bit of a pullback.”