TRADE SUMMARY
- We continue to prefer avoiding positions in AUD/USD with the SELL rating issued at 0.89 on 9/19/2014.
- Our SELL rating has already helped investors avoid market downturns of 255 pips.
ANALYSIS
We remain tactically bearish on AUD/USD.
The recent deterioration in business and consumer sentiment suggests that Australia's growth has reached a peak in the cycle. We believe that government policy stimulus and the inventory cycle account for all of the growth in Australia we have seen so far. The effects of fiscal stimulus and inventory investment are apt to fade significantly in the coming quarters, at which point the onus for growth passes to the private sector. However, the current pace of domestic demand growth looks unsustainable. Looking ahead, our forecast of real GDP in Australia looks for some additional loss of momentum during the next several months.
Australia has a balance of payment problem which is largely driven by the current account balance, and our forecasts show notable deficits in the foreseeable future. Manufacturing in Australia became uncompetitive when emerging market countries set up their factories to provide low-cost products to the world. Australian companies aided in the hollowing out of manufacturing by actively seeking foreign producers, while investing in and setting up factories offshore. AUD/USD is significantly overvalued. All else equal, a more overvalued currency is likely to be more negative for export competitiveness, while imports of foreign goods become relatively cheaper. In the absence of a significant fiscal tightening, which looks politically impossible, a sizeable currency depreciation is needed to put the current account back on a sustainable path.
High external financing requirements make the country dependent on foreign capital. However, foreign participation in Australian government bonds has already descended into a notable downtrend despite occasional recoveries. Lenders to Australia will be asking whether they will get their money back or not. If foreigners sell their Australian debt, interest rates will rise and AUD/USD will weaken.
Historically, weaker demand is associated with currency depreciation in Australia. This is because slower growth will lead to lower real interest rates and weaker return expectations and hence capital inflows. Weakening growth prospects will lead to falling real interest rates. It is reasonable to argue that the shift in real interest rate differentials will contribute to the depreciation in the Australian dollar because they will make Australia's fixed income markets unattractive and push the Australian dollar lower. Those currency investors who share our bearish view should expect risk premium to widen and should be very cautious about any exposure to AUD/USD.
