The Reserve Bank of Australia (RBA) released the minutes of its last monetary policy decision during which it seemed to declare a soft landing for China. I took particular interest in the RBA's assessment of the surprisingly strong Australian dollar (FXA).
The RBA pointed to the strong demand for Australian government bonds as a key support for the Australian dollar (emphasis mine):
"The decline in yields on Commonwealth Government securities was particularly pronounced, with the 10-year yield briefly falling to a historic low just below 2.7 per cent. Offshore purchases of Australian government bonds appeared to have continued apace and, in part reflecting these purchases, the Australian dollar had appreciated over the past month, increasing through periods of both strength and weakness in 'risk-sensitive' assets. Members noted that this had put the trade-weighted measure of the currency back near its post-float high, notwithstanding the decline in the terms of trade and the weaker global outlook."
Just as in the U.S., government bond yields in Australia are at record lows and notably below panic lows from 2008 and 2009.
Australian Capital Market Yields - Government Bonds
The ramp up in foreign ownership in Australian bonds has been significant. On August 6th, Reuters quoted Barclays research with these data:
"Offshore holdings of the A$238 billion Australian sovereign bonds on issue have ballooned to around 83.5 percent, up from 71 percent a year ago and around a third a decade ago…"
Demand for Australian bonds is driven by the scarcity of liquid, AAA-rated government bonds around the globe. Moreover, Australia has little debt and plans to run a surplus in 2013. This will no doubt drive yields even lower. If Australia can sustain its surplus, bond purchases should become a much less significant driver of the Australian dollar. Without growth in supply of the bonds, incremental currency cannot flow into the country to chase yields ever lower. Instead, the same cash flows will mainly recirculate amongst the same volume of bonds.
The RBA also pointed to the possibility that purchases from the Swiss National Bank (SNB) are further strengthening the Australian dollar although this buying may be counter-balanced somewhat by Chinese selling (emphasis mine):
"The further decline in the euro exchange rate put additional pressure on the Swiss National Bank in maintaining the franc's peg against the euro to avert deflationary pressures. Members noted that the Swiss National Bank had purchased around €100 billion over May and June, with further sizeable purchases likely to have occurred in July. While some of these purchases were retained in euros, a sizeable share was converted into other currencies, including a modest amount in the Australian dollar. In contrast, members noted that the level of Chinese foreign reserves fell in the June quarter, as capital outflows occurred."
On balance, the RBA demonstrates little alarm or concern for the health of the Australian economy, pointing to Europe as the key point of risk:
"The forecast for growth in Australia's trading partners had also been revised lower, but remained almost 1 percentage point higher than the forecast for global growth, reflecting the larger share of trade with emerging market economies in Asia…
The forecast for global growth in 2012 was close to its long-term average and growth was expected to pick up somewhat in 2013. Nevertheless, the risk of significant economic and financial disruption in the euro area continued to cloud the outlook…
The economy was…expected to grow at around 3 per cent over 2013 and 2014, largely unchanged from the forecasts presented in May. Resource investment was forecast to peak during 2013/14 and gradually decline over subsequent years, although the timing of the peak was uncertain, with the boost to growth coming from higher resource exports and a gradual rise in non-resource investment."
Business credit is also now growing at its fastest pace in 3 1/2 years.
Although the RBA did partially blame the high exchange rate for earlier weakness in the non-resource sector of the economy, overall, the RBA minutes do not include any strong language suggesting any urgency about bringing the currency down. In fact, by noting both that earlier rate cuts have tentatively started to turn the housing market around and that it will take time for these cuts to exert their full impact, I believe the RBA suggested that no further rate cuts will occur anytime soon - again, unless the sovereign debt crisis in Europe takes a significant turn for the worse. At the time of the RBA meeting "the improvement in sentiment after President Draghi's announcement had seen money market participants in Australia curtail their expectation of further cuts in the cash rate target."
As I stated in my last piece on the Australian dollar, I opportunistically switched to net long in the Australian dollar to play a (short-term) bounce. This bounce is apparently now underway…
With stochastics greatly oversold, AUD/USD should experience a healthy bounce from current levels
Be careful out there!
Additional disclosure: In forex, I am net long the Australian dollar