The Invesco ETF (FXA) currently holds $107 million USD worth of Australian dollars and has been on a very long decline that began in 2012. Today, as the AUD/USD exchange rate hovers around its 2009 low, we believe it is an excellent short- and long-term opportunity for the right kind of investor. Australia exports an extremely high level of hard commodities and has had a trade balance that has risen dramatically in recent years. As commodity prices continue to reverse to the upside, we believe AUD/USD is poised for an excellent short-term breakout. Further, if the commodity super-cycle finally flips back to bullish, we have reason to believe the exchange rate may rally 50% or more over the next five years.
Here is a chart of the Aussie dollar's trend channels since its bear market began in 2012:
(Data source: Yahoo Finance)
As you can see, the currency has had a rough ride in 2012, with the exchange rate itself falling from 1.08 in February 2012 all the way to 0.69 today. This has tracked a long fall in global commodity prices that hit a precipice in 2015 and its considerably interest rate differential to the US dollar. Since then, the downtrend in the currency has slowly been fading, and it appears sellers have run out of space to the downside.
As you can see above, the price is at a very long-term support level of 0.70 (or $70 on the ETF). This support level has been in place since 2004, and because the currency is highly correlated with hard commodities, there are real physical limits to how far the currency can fall beneath that level.
Here is a chart of the exchange rate since 2004:
The exchange rate had an extreme drop in 2009 as commodities that were being propped up by speculation plummeted. Next, the currency quickly rose over 50% as QE fears and precious metal speculation caused gold and silver to rapidly double in value. As the commodity super-cycle turned over in 2012, the Australian export economy lost considerable ground and the internal economy shifted its focus toward Real Estate speculation.
We are actually extremely bearish on the internal Australian economy, as the housing piper is finally being paid and his bill is incredibly steep. But as far as exports and interest rate differentials are concerned, we believe the story is the opposite.
Interest Rate Differentials
In the modern interconnected economy, foreign exchange rates are based primarily on interest rate differentials and secondarily on trade balances. As home prices have been falling (and as the RBA has helped propped them up), short-term interest rates have been in a steep decline in Australia. Here is a chart of the 3-month rate vs. AUD/USD since 2004:
(Data source: U.S Federal Reserve)
Directly from the chart, it appears the differential is on a steep decline but is about to reach its 1997-1999 Asian financial crisis low of 1%. The Australian economy is leading that of the United States and has been cutting rates for quite some time to slow housing market turmoil. Put simply, the Australian Reserve Bank has been using its exchange rate to try to bail out real estate investors, and the trick cannot go on much longer without causing serious political risk in the country.
Confirming the support level in the charts, the U.S Fed and the RBA are finally meeting on the same page. The Federal reserve has repeatedly started to signal that it may cut rates soon, while the Reserve Bank of Australia has signaled that it will "more likely than not" cut rates again in July. The difference between the two is the United States is just starting to become dovish, while the Australian bank is starting to look to end its dovish stance to protect its exchange rate from collapsing further.
Most likely the differential will become flat over the next 1-3 months and may subsequently see a similar pattern as in 2006. As rate expectations rapidly reverse and carry traders are forcibly squeezed, the exchange rate should very rapidly change directions.
As Chinese demand for hard materials has crashed, global commodity prices have hit rock-bottom. This has been difficult for Australia to combat, particularly for its exchange rate and trade balance. While it seems unlikely for the Chinese economy to improve anytime soon, they will most likely shift their purchasing from the United States toward Australia and Brazil, specifically for petroleum and agricultural products.
On top of that, it seems those commodities Australia exports may be turning to the upside on inflationary and supply-side concerns.
Australia's top exports are as follows:
And here is a chart of those top four exports compared to the exchange rate:
Quite clearly, we can see that the commodity super-cycle topped out in 2012 as well as the Australian dollar, and appeared to have bottomed out in January-February 2016. The first phase of the next cycle has been extremely choppy and precarious, but as producers exit the market due to low prices (as has been occurring in coal and oil), geopolitical risks in the Middle East threaten supply, and as re-emerging QE stimulates global safe haven currency devaluation, it seems likely these commodities will continue to rise.
Risks and Rewards
The primary risk to this trade is not that there will be a recession, but that if there is one, it will disproportionately affect real assets as occurred in 2008-2009. This would mean continued industrial slowdowns and a pause to infrastructural development. While it is unlikely for the Chinese infrastructural boom to return anytime soon, demand from the United States may actually rise due to its need for road, building, and possibly wall, refurbishment. Of course, it is nearly impossible to estimate how much that figure will be and how it will specifically impact Australia, but it will certainly be large enough to materially impact that economy. Still, if commodities reverse their recent gains and make new lows, then it will definitely harm the currency.
The secondary risk we see is more likely than the previously mentioned commodity crash but much less of a risk in magnitude. It is that the RBA will continue to be more dovish than the U.S Fed. This is more likely because it is a tight trend already in existence, but less of a material risk because it can only go on so much longer before the public becomes concerned about the value of their currency. On top of that, if the RBA continues to be dovish, it would imply the global economy is becoming more bearish, including that of the United States. So, a dovish RBA would almost certainly be matched by a dovish Federal reserve in months to come, so this risk is mitigated. Of course, some do believe the U.S economy could grow while the rest of the world falls. We do not accept this argument, but if it holds true, it would be bearish for AUD/USD (FXA).
Overall, we see 5-15% upside by the end of this year as these events and trends come to fruition and 40-70% upside over the next five years if global supply constraints/shocks push the Australian trade balance to new highs.
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.