AUD/USD: It's A Long Way To The Bottom

Includes: FXA
by: Evariste Lefeuvre

Now that the RBA [Reserve Bank of Australia] has cut its cash rate to 2.75%, the lingering question remains unanswered: why does the AUD/USD stubbornly remain above 1.01?

The cut was motivated by GDP growing "below trend" and the risk of a further weakness in the resource sector (engineering investment is up to 7% of GDP compared to 2% in 2002; mining makes up more than 40% of total investment compared to 10% in 2001). The oncoming peak of the mining investment boom may not be offset by a rebound in other parts of the economy, which can explain the preemptive action of the RBA, as well as its easing bias.

The Australian OIS curve is close to fully pricing in a further 25bp cut in the coming months (left chart below). Yet, as the second chart shows, the OIS swap curve spread between the US and Australia does not call for further weakness in the pair.

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The slowdown in mining activity has already been priced in by the equity market as can be seen below. The ratio of the Metal & Mining subcomponents of the SP 500 and the ASX 300 used to point towards a weaker AUD/USD, but both series seem to have recently recoupled.

Even the year-old disconnect between the AUD/USD and copper prices seems to have (temporarily) come to an end as both 1-month changes in the series have recoupled (chart, right).

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From a cross asset point of view, it looks like the AUD/USD is more a laggard than an early trend adopter: the Aussie disconnected with JNK and SPY 3-month returns (see below).

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From a monetary policy, cross asset, and commodity market point of view, the AUD/USD does not seem overvalued at all. The economy might be a guide.

The link between AUD/USD and the relative news flow between Australia and the U.S. is inverted. When Australia's news flow is better than that of the U.S. the Aussie tends to be weaker and conversely. The reason is straightforward in a risk on/risk off environment:

Better news flow in the U.S. => stronger global risk appetite => over performance of high beta currencies => higher AUD/USD

The weakening of China has also been put forward as a cause for a weaker AUD/USD. As can be seen below, 15-day changes in the AUD/USD still tracks the news flow in China quite well. But the mispricing here is limited as the suggested decline for AUD/USD is -1.5%.

The Australian Current account is close to 4% of GDP. The macroeconomic backdrop for the deficit is not really comforting as the debt-to-GDP ratio of the private sector remains high while the flow of Foreign Direct Investment has recently dwindled.

We know since the failure of Reinhart and Rogoff that there are no thresholds in economics, but the debt-to-disposable income of Australian households stands at slightly less than 150%, while interest payments stand at 10% (even though the saving rate has also risen from 5 to 10% between 2008 and today).

The odds for a much weaker AUD/USD may seem limited when cyclical economic data and cross asset factors are taken into account. Yet as we rely less than ever on the risk-on/off mantra I remain sensitive to, and concerned by, two points:

First, the spread of real interest rates s clearly pointing to a weaker AUD/USD. As long as it suggests that the growth model of AUD may be at risk, I would give some credit to this indicator.

Second, the mining sector situation is pretty horrid: miners in Australia are cutting costs, closing mines and scaling back investments. The Mineral Resource Rent Tax isn't helping either, as profits of the mining sector are scaling back to their 2009 levels.

Thus, in spite of cyclical and market signals pointing to a strong or well-priced AUD/USD, the odds for the Aussie to fall below 1.01 are still quite significant.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.