After the Reserve Bank of Australia (RBA) cut interest rates on Monday night, the Australian dollar (FXA) bounced down, up, drifted lower, and then rallied. It is too easy to call this a classic case of the market doing the opposite of expectations once news gets released. Instead, this apparent contrary action is simply part of an overall resilience in the Australian dollar that has been on display for quite some time.
This resilience is presenting quite a challenge to the RBA as it attempts to weaken the currency through rate reductions. It is becoming more and more clear that the RBA will have to drive rates a lot lower before it can get the market's attention, yet such a move seems unwarranted without a major economic crisis. Notably, nothing in the RBA's statements indicate that the economy is experiencing major weakness or even that such weakness looms over the horizon. Here are some telling quotes from the last statement on monetary policy:
Capital markets remain open to corporations and well-rated banks, and Australian banks have had no difficulty accessing funding, including on an unsecured basis. Borrowing conditions for large corporations are similarly attractive and share prices have risen since mid year…
…most indicators available for this meeting suggest that growth has been running close to trend over the past year, led by very large increases in capital spending in the resources sector, while some other sectors have experienced weaker conditions. Looking ahead, recent data confirm that the peak in resource investment is approaching. As it does, there will be more scope for some other areas of demand to strengthen…
…Inflation is consistent with the medium-term target, with underlying measures at around 2½ per cent… The Bank's assessment remains that inflation will be consistent with the target over the next one to two years.
The only area of domestic concern seems to be that private consumption will grow "but a return to the very strong growth of some years ago is unlikely," and non-resource investment remains "subdued." There are a LOT of developed economies which can only dream about having Australia's "problems."
The RBA's real concern shows up again in its statements about the currency. A stubbornly strong currency could cause trouble for Australia next year as costs in the resource sector continue to climb, commodity prices drop, and the country then will need to look to other industries to support exports. From the RBA:
There are signs of easier conditions starting to have some of the expected effects, though the exchange rate remains higher than might have been expected, given the observed decline in export prices and the weaker global outlook.
The RBA's concerns regarding the strong currency are supported by an assessment of the Australian economy conducted by the International Monetary Fund (IMF) back in September. During the IMF's visit to the country, the organization concluded that "Australia's financial system to be sound, resilient, and well-managed." However, the IMF noted several times that the currency's strength could be an impediment to future economic growth, and it supports accomodative monetary policy as a tool for driving the currency lower (I also duly noted how often the IMF lauded Australia's support for a free-floating currency):
We support the authorities' move toward a policy-mix that combines a tighter fiscal policy with an accommodative monetary policy stance, which will help ease pressure on the exchange rate. The fiscal consolidation is consistent with a policy setting where monetary policy plays the primary role in managing demand.
The IMF provides a detailed explanation for the stubborn strength in the Australian dollar:
…in recent months the Australian dollar has remained high despite lower commodity prices and the weaker global outlook…a number of factors [contribute] to the current high level of the Australian dollar, including the relative strength of the Australian economy, the gap between domestic and foreign interest rates and to some extent increased portfolio investments into Australia…portfolio reallocations of large reserve holders toward Australian government debt.
The IMF warns that continued strength in the currency could boost Australia's current account deficit and notes that efforts to boost savings will help relieve the pressure:
If these factors were to ease, the exchange rate would likely depreciate, reducing the current account deficit over the medium term and limiting the reliance of banks on borrowing abroad. The government's fiscal consolidation should also ease pressure on the exchange rate by boosting national saving, and additional steps to limit the projected decline in private saving, such as the planned increase in superannuation contributions, are appropriate.
…We expect the current account deficit to widen this year to 4 percent of GDP as import volumes pick up, especially for capital goods, possibly reaching 6 percent by 2014… a strong Australian dollar plays a necessary role in reallocating domestic resources towards mining away from other tradable sectors, accelerating structural change. Nevertheless, we estimate that the exchange rate is currently stronger than would be consistent with this adjustment alone, and at its current level, if continued, would result in a further increase in non-mining related net foreign liabilities going forward…
Overall, the IMF's report is a well-balanced contrast to some of the bearish assessments I have read that almost exclusively focus on and highlight the negatives and risks in the Australian economy. While the IMF concludes that "risks are tilted to the downside and are primarily external," it assigns a very low probability to a hard landing in China and provides an optimistic forecast:
The outlook for the aggregate economy remains favorable, primarily driven by domestic private demand…Fundamentals have improved since the global financial crisis; household and business balance sheets have strengthened and banks have reduced their use of foreign funding.
While the relatively strong Australian dollar seems ready to stay aloft for quite some time - at least until the RBA gulps hard and sends rates much, much lower - the Japanese yen looks like a strong currency on its way to a major correction. I refreshed the arguments for weakness in "This Time Should Be Different - Fade The Japanese Yen." At that time, I was specifically focused on the advantage of the U.S. dollar over the Japanese yen (FXY). The Australian dollar's main advantage is a wide interest rate gap that will likely only close slowly, making the yen a likely target funding currency in 2013 if its weakness continues. On the way there, holders of AUD/JPY get paid for waiting.
Last week, I pointed out some likely targets for starting fresh fades of the yen. USD/JPY hit that target Tuesday night and promptly bounced.
USD/JPY bounces off the 20DMA as consolidation continues off overheated uptrend
The Australian dollar looks even better against the yen. It broke out against the yen in mid-November and is now heading for the top of a long-standing trading range.
The Australian dollar broke out against the yen last month
Since the financial crisis, the Australian dollar has held its own against the Japanese yen
The top of that range will be AUD/JPY's next major test. I am willing to play this trade until that point, assuming that the market's fight against the RBA continues to succeed. I recognize that I am talking myself out of my (marginally) bearish bias against the Australian dollar, but it seems at this point to make sense to begin a transition to a method that reacts to weakness from one that attempts to anticipate it. In the meantime, I will watch AUD/JPY's progress through the long-term trading band and selectively short AUD/USD when a pullback appears imminent (like now where 1.05 seems like a natural short-term resistance point).
Be careful out there!
Additional disclosure: In forex, I am long AUD/JPY and short AUD/USD.