Trading currencies like the Australian dollar is typically a short-term exercise. Many banks such as Citi (C) and JP Morgan (JPM) have big currency trading operations that allow them to take advantage of the flows. When they see buyers come in, they buy, and vice versa. I'm an investor and see no flows at all, but if I take a longer term view, I don't need to go head to head with these large franchises. I can wait for moments when I think the risk-reward is materially in my favor. With the Aussie, we're at one of those moments now.
Let's build a case for a position in the Aussie. We'll look at its purchasing power, the Australian trade balance, and its interest rate differential - that is, the three things I believe to be the main drivers of the price of this currency. Then as a check, we'll look at two related markets to see whether the Aussie is trading where it "should," or if it is becoming out of line.
In the long run, the purchasing power parity ("PPP") of a currency is one of the main determinants of its price. (We have to be cautious though, because the long run can be very long indeed.) PPP measures the "fair value" for a currency. In other words, if the price of things in Australia is about 10% higher than in the US, we would say the Aussie is about 10% overvalued. That is, if the price of the Aussie were to decrease by 10%, the cost of things would be about the same in the US and Australia.
There are different ways to calculate PPP, and in the case of the Aussie, they're all painting a similar picture. Bloomberg's PPP model pegs the Aussie at 30.6% overvalued. The Economist's Big Mac Index, a simple tool that compares the price of Big Macs in both countries, shows the currency to be 35.3% too expensive. The OECD's PPP, based on baskets of goods and services, suggests the Aussie is 40.5% overvalued. By all three of these measures, the Aussie is one of the most expensive currencies in the world.
One of the reasons that a currency like the Aussie can stray from its "fair value" is demand for that country's exports. If there is huge demand for Australian exports, that demand can keep the currency at expensive levels for months or years. The simple reason is that the importers of Australian goods need to buy Australian dollars to pay for those goods. In the case of the Aussie, I'm most interested in Australia's trade with China because of China's very strong demand for Australian resources.
click to enlarge
This graph charts China's imports from Australia. As we can see, it dipped during the worst part of the recession in 2008, but then resumed its upward trend. There was a dip early last year that looks suspiciously like an error, but apart from that the trend has been up--until now, perhaps. It's a bit early to tell, but last month's drop is worth noting.
Although it's too early to tell, this weakness may continue. Here is a graph of China's new export orders index:
As you can see, global demand for Chinese exports is beginning to flag, and this supports the possibility of further weakness for Australian commodities. Less demand for Australian exports means less demand for the Australian dollar. Global trade with Australia has been fairly flat for the past 18 months or so, suggesting a stagnant if not weaker picture.
One of the biggest factors driving the Aussie up through its PPP fair value has been the interest rate differential. An investor holding the Aussie can earn 4.00% on 10-year Australian bonds, and 3.60% on 5-year bonds. This compares very favorably with comparable US treasuries, paying only 1.96% and .80% respectively. This difference creates investor demand for the Aussie since investors can earn much more interest holding the Australian dollar.
The chart above shows the Aussie in blue and white, overlaid with the 5-year interest rate differential between Australia and the US, in red. In general, as you can see, the higher the relative interest rate of Australian bonds, the more demand for the currency. Lately, however, this differential has been decreasing, even though the Aussie has remained firm. This disparity is further evidence that the Aussie may be running out of steam.
There is no doubt that the interest rate differential, at about 2.8% in 5-year government bonds, provides strong support for the Aussie. Everyone wants to earn 3.6% rather than 0.8%. The key question, however, is how that relationship is changing. As we can see, the difference between the two has been decreasing over time. This factor is important, because holders of Aussie dollars are subject to currency risk while they're paid that higher rate of interest.
We've seen that the Aussie is expensive in terms of what it can actually buy; we've seen that trade with China is wobbling; and we've seen that Australian rates are diminishing in attractiveness. As a last step we'll look at the relative position of the Aussie when compared to two assets: the basket of Asian currencies (the "tigers," primarily), and the CRB commodity index.
Let's begin with the Asian currency basket, or ADXY1:
We can immediately see that the two assets track each other very closely, particularly up until about six months ago. For clarity, the circle shows the current position of ADXY against the Aussie. Although the divergence is not large, we can see that ADXY has not participated in this most recent Aussie move up to the 1.07 area.
Finally we will look at the Aussie together with the CRB index:
Here we can see a more striking divergence, with the CRB showing clear signs of weakness while the Aussie remains near its recent highs. If we assume that the Aussie is in fact a "commodity currency," this relationship also provides us with a heads-up that the Australian dollar may be losing its shine.
Just over ten years ago, in the spring and fall of 2001, the Australian dollar was trading below fifty American cents. At that time, the Aussie was very cheap, as history has proven. Although Australia and its dollar have many positive features - healthy, growing economy, proximity and trade with China, relatively high interest rates - these attributes are more than reflected in the price of its very expensive currency.
The Aussie is due for a material correction. At the most recent meeting of Australia's central bank on February 6, the RBA unexpectedly kept its key short-term rate at 4.25% rather than cutting it to the expected 4%. This gave the Aussie a boost that contributed to its 10% rise from mid-December. But that may be the Aussie's last hurrah for a while. The Aussie is very expensive, and nothing goes up forever.
(All charts courtesy Bloomberg)
1 The ADXY currency basket consists of the Chinese Yuan, Hong Kong dollar, Indian Rupee, Indonesian Rupiah, South Korean Won, Malaysian Ringitt, Philippines Peso, Singapore Dollar, Taiwan Dollar, and Thai Baht.
Additional disclosure: I have a short position in the Australian dollar.