- Australian bonds now yield less than US bonds for the first time since 2000
- The last time this happened the Australian dollar was a 50 cents, well below where it trades now
- Macquarie Bank says the key difference between now and then is strength in commodity prices
For the first time since Sydney was hosting the Summer Olympics back in the year 2000, the spread between Australian and US 10-year bond yields has turned negative.
The former sits at 2.87%, the latter at 2.95%.
Despite losing its yield advantage to the US dollar, the Australian dollar seemingly doesn’t care, sitting at a still lofty 78 cents today, well above the 50 cent level it traded at when spreads went negative last.
Just look at the gap that’s opened up between the AUD/USD and 2-year Australia-US bond spreads — those more aligned with near-term interest rate outlooks — over the past couple of years.
The yield advantage has evaporated, yet the Aussie is grinding higher.
So what gives? Why is the Aussie not back at 50 cents given the reversal in spreads?
To Macquarie Bank, the answer is pretty simple: commodity prices.
“The key difference between now and 2000/01 is that the prices of Australia’s resources exports are around 180% higher in USD terms and the terms of trade are up nearly 60%,” it says.
Pointing to the chart below, Macquarie says “mdelling of the fundamental value of the Australian dollar shows that the terms of trade is by far the most important determinant.”
Terms of trade is the value of Australia’s exports divided by its imports and then multiplied by 100.
Clearly, where it moves, the Australian dollar tends to follow.
Macquarie says that while interest rate differentials do have some influence over the exchange rate, it’s far smaller than the influence of commodity price movements.
“Interest rate spreads are significant but play a much smaller role as a fundamental driver of the AUD, nor do they have a consistent correlation with short-term moves in the currency,” it says.
It points to the first highlighted section in the first chart to underpin this view.
Like now, despite a sharp narrowing in Australian and US bond spreads, the Aussie wasn’t impacted as China’s commodity binge hit full flight, leading to substantial increases in prices.
As such, Macquarie says rather than being led lower by bond spreads, where the Aussie heads next will be determined by commodity prices, meaning the outlook for the Chinese economy will also play a major role given it accounts for so much global demand.
“China is king,” the bank says, adding that its commodities team expects the prices for Australia’s key bulk commodity exports to “decline over the next two years which would weigh on Australia’s terms of trade.”
“This view for lower bulk commodity prices revolves around the importance of China in these markets and our China economist’s expectation that commodity-intensive growth slows further,” it says.
Macquarie says a 20% fall in Australia’s terms of trade could see the AUD fall back to low 70 cent region by the end of 2019. Alternatively, it says an increase in terms of trade of 10% could see the Aussie trading as high as 85 cents over the same period.
It’s base case is for terms of trade to decline by only 4-5% by the end of next year.
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