A slowing housing market
Over the past few years, many economists and commentators have warned of a potential hard landing in the Australian housing market, as property prices have been growing at unsustainable rates with first-home buyers having difficulties saving a significant deposit to get a foothold in the market. According to the Australian Bureau of Statistics, the AU property market is worth approximately USD7tr, by far the economy's largest asset. Between 2012 and 2017, the two major cities, Sydney and Melbourne, experienced a price appreciation of 80% and 60%, respectively, pushing the median house-price-to-income ratio to record levels (multiple of 12 according to some estimates). However, in the past two years, house prices have fallen into a bearish trend, down 5% on average for the top 8 biggest cities on an annual basis (figure 1, left frame). Hence, with banks' mortgages equivalent to roughly 80% of the country's nominal GDP (figure 1, right frame) with a non-existent loan loss provisioning as default rates have been close to zero percent, shorting the banks has been one way of shorting the housing market in Australia.
Another interesting way of playing this trade is to simply short the Australian dollar as the RBA's response to counter the downside in housing would be to cut rate quickly to zero, which will definitely be reflected by a depreciation of the currency. We think that in addition to the weakening signs of the housing market, there are different market forces that will weigh on the Australian dollar in the coming months.
Should investors worry about the weakness of the Aussie?
Since the early 2000s, the Aussie has been usually defined as one of the main leading indicators of the global economic activity, implying that the Australian dollar should appreciate in periods of global growth and reflation and should depreciate in periods of economic slowdown. For instance, figure 2 (left frame) shows that the 2016 reflation was expressed by a rise in both the Aussie and copper (both considered a leading indicators), significantly helped by loose credit conditions in China. The green line shows the Chinese credit impulse, measured as the annual growth of Total Social Financing, which we usually use as a leading indicator of global equities (6M lead). It is interesting to see the strong co-movement between the Aussie and copper and the Chinese credit impulse since 2004.
However, we can notice that over the past two years, the Australian dollar has not been reacting to positive market news and has been actually diverging from other leading assets such as commodities or equities. Figure 2 (right frame) shows the divergence between AUDUSD and copper that has occurred since the middle of 2017, which raises the following question: which asset should we trust?
We can also observe a similar divergence between the AUDJPY exchange rate and world equities in the past 3.5 years. As the Japanese yen is usually considered as a safe-haven currency that tends to appreciate in risk-off environments, we use the AUDJPY cross rate as a barometer of risk. Figure 3 (left frame) shows that AUDJPY has significantly co-moved with global equities since the early 2000s, indicating that a trending AUDJPY is representative of a rising risk-on environment, which is usually good for stocks. However, the trend on AUDJPY has been bearish since the beginning of 2016, falling from approximately 90 to 75, while equities have been trending higher. The divergence may be less apparent if we look at the world equities excluding US stock market (figure 3, right frame), but we can still notice the AUDJPY has been constantly pricing in lower equities in the past 18 months.
RBA and outlook for the Aussie
The Reserve Bank of Australia (RBA) left its cash rate unchanged at 1.5% in May (same level since July 2016) despite the fall in the country's rate of inflation. Australia CPI annual inflation rate rose 1.3% in the first quarter of 2019, down from 2.1% in Q2 2019, despite the strong labor market as Governor Lowe commented in the May statement. Figure 4 (left frame) shows that the fall in inflationary pressures in China, with the PPI inflation rate plummeting from 7.8% to 0.9% in the last two years, has been weighing on Australian prices. We use the PPI inflation rate as a proxy measure of Chinese inflation as China government bonds are more sensitive to the dynamics of PPI prices as we can notice in figure 4 (right frame).
Even though the RBA is expecting the pace of inflation to gradually accelerate to 1.75% and then 2% in 2019 and 2020, respectively, the negative forces on the Australian housing market will push policymakers to maintain a loose monetary policy in the medium term. With the 30-day interbank cash rate futures August 2019 contract trading at 98.73, the market has fully priced in a cut to occur this summer. In addition, participants expect another cut to occur in the beginning of next with January and February 2020 contracts trading above 99. This will definitely continue to weigh on the Aussie in the coming months as the interest-rate differential will continue to favor the US dollar in this current economic environment (figure 5, left frame).
Last week, we saw that AUDUSD retested its January 2016 low of 0.6860, with momentum indicators clearly showing a bearish trend on the exchange rate. However, it is difficult to short the pair at current levels, especially after the 15-percent depreciation that occurred in the past 16 months. Next support stands at 0.6230, which corresponds to the October 2008 lows (figure 5, right frame). We are still negative on AUDJPY, our proxy for shorting equities (see our FX weekly), but we would wait for a little bull consolidation to start shorting AUDUSD at higher levels.
Disclosure: I am/we are short USDJPY. 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.