AUD: Highly Dependent On China

by: Citylytics

US-China trade tensions and fears of China growth slowdown weighted heavily on the AUD in December.

The RBA clearly shifted to a neutral stance from a previously slightly restrictive monetary stance in response to the worsening external environment.

In the short term, the AUD will benefit from the expected US-China trade agreement.

Ongoing China growth slowdown will harm the Australian economy in the rest of the year due to high export sector exposure which will lead to the AUD depreciating.

Worsening Australian economic and inflation data in combination with fears of Chinese growth slowdown weighed heavily on the AUD through the course of December. Furthermore, concerns about the US-China trade conflict put considerable pressure on the AUD and the market started questioning whether the Reserve Bank of Australia (RBA) will indeed hike rates this year.

Chart 1: AUD/USD movements

AUD/USD Source: Reuters

Indeed, the trade dispute between the US and China is a negative factor for the Australian economy. China is by far Australia’s most important trading partner and developments in China therefore have a direct impact on the demand for Australian goods. Chinese officials have been easing policy settings for several months in order to prevent stronger growth deterioration.

We have seen something similar in 2016. However, China currently has far less ammunition to combat weakening growth – debt levels are higher, the fiscal deficit wider and interest rates lower than at the onset of the previous slowdown. Chinese real GDP growth is slowing down without a doubt and China will not be able to provide the same level of support for the Australian economy as it did just a year ago.

Chart 2: Direction of the Australian export (2017-2018) Source: Australian Government - Department of Foreign Affairs and Trade

Australia's retail trade data in December came in weaker than expected. Nominal sales declined -0.4% MoM while sales volumes grew a modest +0.1% QoQ over 4Q2018 as a whole. Spillovers from falling house prices in Sydney and Melbourne appear to be growing and are having a negative impact on the personal consumption performance. As for sentiment indicators, Australia’s PSI survey (Australian Performance of Services Index) fell -7.8 points to 43.3 in January, indicating the first contraction in Australia’s services sector since early 2017. Inflation remains low and just below the RBA target range of 2-3% due to continued weak wage growth.

Chart 3: Core consumer price movements (YoY)

Source: Reuters

The RBA left the cash rate unchanged at its February meeting as it was widely expected. However, the RBA stressed that downside risks to both the global and domestic outlook have increased. In the statement following the meeting, the RBA removed the language “the Australian economy is performing well” and noted “some downside risks have increased.” The RBA was also less positive on the global outlook as it noted that activity had slowed in the second half of 2018 and that the trade tensions are affecting global trade and investment decisions.

The RBA highlighted the uncertainty around the outlook for consumption as governor Lowe stated at the RBA's first board meeting of the year: “The main domestic uncertainty remains around the outlook for household spending and the effect of falling housing prices in some cities.” Core inflationary pressures will not be able to accelerate if personal consumption deteriorates further.

On monetary policy, RBA Governor Lowe significantly softened the RBA’s tightening bias by stating: “Over the past year, the next move is up scenarios were more likely than the next move is down scenarios. Today, the probabilities appear to be more evenly balances.” The latter shows that the RBA is now taking greater account of global risks and has clearly shifted to a neutral stance from a previously slightly restrictive monetary stance. While a rate hike is just a probability and will happen only in case of global risks realization, the RBA clearly has no reason to hike rates either this year.

In the short term, the AUD movements will be driven by external factors. The focus remains on the trade talks between the US and China. The Financial Times reported that the US president Donald Trump opened the door to extending trade talks with China past the current March 1 deadline to avoid escalation of tariffs, saying he could allow more time for negotiations if Beijing and Washington were close to a breakthrough. The US clearly wants to reach an agreement with China and will probably do so in the coming weeks. The AUD is therefore set to appreciate accordingly in the near term as fears that caused significant depreciation pressures will be dissolved.

However, as I showed above, the Australian economy is highly dependent on China. Chinese and eurozone growth slowdown will harm the economy through the course of this year. Besides the latter, internal factors such as falling housing prices will weigh on the overall economic performance. On the other hand, the USD will benefit from much stronger fundamentals, higher interest rates and the perception of the USD as a safe haven currency.

With all that being said, I believe that the AUD/USD pair will move lower by the end of the year. There are two good chances for trading: 1) Buying the AUD now when the US-China trade deal is still uncertain and then taking profit after the trade deal is reached and 2) shorting the AUD once it appreciates in the aftermath of the US-China trade agreement due to worsening economic conditions.

Disclosure: I/we 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.