About a month ago I posted here on the Australian dollar and why I thought it was an attractive short. To sum up that post, the Aussie is expensive in terms of purchasing power parity; Australian exports are waning, along with China's; and commodities, at the core of 19% of Australia's economy, are weakening in price, displaying less global demand. At the same time, I acknowledged that Australia's interest rates are higher than those of the US, which explains at least some of the enduring strength of the Australian currency.
Since then, the Aussie has moved down by about 2%. It is fair to say that the Australian dollar is still expensive in terms of purchasing power parity. Also, as we can see from the chart below, the Aussie (blue) is clearly diverging from an index of industrial metals (red). In addition, just yesterday German car makers announced markdowns of up to 25% for Chinese auto buyers, so it would seem the Chinese economy has not strengthened since last month. These factors suggest the Australian dollar may be headed still lower. (Source for all charts: Bloomberg)
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If we are to maintain or add to a short position, it is worth examining the investment aspect of the Aussie dollar. After all, with an interest rate differential of 2.66% in favor of Australia in 5-year government bonds, the higher rate provides a major incentive for investors to hold the Aussie. This is especially true since the rate of inflation of the two countries has been very similar over the past decade, as we see below:
This graph represents the inflation differential between Australia and the United States. The difference is derived by taking the Australian "year on year" rate of inflation minus the corresponding US rate. As we see from the red horizontal line, on average over the past ten years Australia's inflation has been 0.5% higher than that of the US--the two rates have been remarkably similar. Interestingly, the trailing 3-year average (pink line) shows that the differential has averaged 1.06% over the past three years, indicating that Australia's average inflation has risen somewhat relative to the US.
This is important when we consider the interest rate differential:
We see that the Australian government 5-year bond yields about 2.66% more than the US 5-year treasury note. This difference explains the attraction and strength of the Aussie to a large degree, but we can see that this differential is trending down from its high of about 4%. We can also see a sharp drop over the course of this month, from 3% to its current level of 2.66%. Remember, though, that Australian inflation has been running about 1% higher than the US, and is trending higher. The net benefit to investing in Australian bonds over US bonds is only 1.6% net of inflation.
If we compare Australian equities to American ones, the relative attractiveness of the two markets is more open to debate. The trailing price to earnings ratio of the S&P 500 as of last night's close is 14.54, while the price to earnings of the Australian counterpart is 14.31. In other words, relative to the price, US stocks earn slightly more.
On the other hand, the dividend yield of Australian stocks is clearly higher, at 4.82% vs the S&P 500's 1.96%. Interestingly, this differential at 2.86% is remarkably close to the interest rate differential of 5-year government bonds, at 2.66%. (Taking into account inflation, as we did with interest rates, the gap is about 1.06% less.)
Of course, the merits of the two equity markets are a question of investor preferences and analysis. The Australian market is of course more exposed to commodity prices and to China's economic growth. In addition, Australia arguably has more ability to stimulate its economy by lowering interest rates, since US rates are near zero. Whatever the relative merits, as we can see below, US stocks have been outperforming those of Australia for some time now, since the end of 2009:
This longer-term chart going back to 1996 shows the Australian dollar in blue, and the relative strength of the Australian and US equity markets in red. The red line falling indicates US stocks are outperforming, and vice-versa. In other words, money has effectively been flowing out of Australian stocks and into American ones, though this depiction is a bit oversimplified. It is safe to say that the relative strength of the two stock markets has coincided with the ebb and flow of the Australian dollar, and that apart from the financial distress of 2008-2009, the relationship has been rather strong.
With an inflation rate of only about 1% more than the US, there is no doubt that the higher "real" yields on offer in Australia give an incentive to investors to hold the currency. This difference is a plus, of course, but may not be sufficient to keep the currency at a very expensive premium of 39.5% to the US dollar in terms of OECD purchasing power parity. In terms of real interest rates, it is relatively inexpensive to short this overvalued currency. With waning interest in Australia's commodities, the risk-reward has tilted in favor of the sellers.