The Australian dollar is one of the most expensive currencies in the world at present, even after its recent decline, and the forces are aligning to suggest it’s going even lower.
That’s the view of Deutsche Bank’s London research team who believe that the prospect of significantly lower interest rates, along with risks associated with China’s economy and Australia’s residential housing market, mean that investors should consider selling the Aussie against the US dollar, euro and Japanese yen.
Here’s Deutsche on why a series of further rate cuts risks fueling a rapid reduction in foreign capital inflows into Australia’s bond market.
To begin with, we see the RBA cutting rates to 1.25% or lower by May 2017. As Philip Lowe succeeds Glenn Stevens in September, risks are skewed toward 50bps of easing being frontloaded into 2016, with the market pricing only 28bps by year-end. The main risk to our dovish view — rapid depreciation — still favours shorts.
They elaborate on why this could see offshore demand for Australian fixed income assets slow to a crawl, even if the RBA doesn’t cut rates as far as it currently expects.
Even if there is less easing in the pipeline than we think, it should be enough to trigger a structural break in flows. As yields convergence with Fed funds, Australia’s balance of payments will require a much lower AUD. The economy depends on bond inflows to fund its large and persistent current account deficit, as FDI inflows have been in structural decline.
Importantly, net bond inflows are a non-linear function of the long-term yield spread. Past data suggest that bond inflows will fall off a cliff if the current 10Y yield spread drops below the current level.
The chart below, supplied by the bank, explores the relationship between yield differentials between US and Australian 10-year bond yields to net inflows into Australia’s bond market as a percentage of GDP.
As it clearly demonstrates, as the yield differential between the two nation’s narrows, the level of inflows into Australia’s bond market tends to slow rapidly.
Along with the prospect of slower foreign capital inflows into Australia’s bond market, which would ease demand for the Australian dollar, Deutsche are also concerned about the outlook for Australia’s housing market, suggesting even a shallow correction in house prices could hinder growth in household consumption, something the government and RBA are both banking on to help underpin economic growth in the years ahead.
“A potential Labor win in the elections on 2 July and the prospect of negative gearing reform could put a dampener on house price inflation and lower the RBA’s bar for easing aggressively with a view to meeting its core inflation target earlier than currently forecast,” says Deutsche.
Even without the perceived risks which that may bring, the bank still suggests that there are a multitude of risks facing the housing market, adding downside risks to household spending levels should they turn from risks to reality.
“Politics aside, there are other potential triggers for a house price correction in the near term,” it says.
“Anecdotally, property demand has already come under pressure as capital controls and anti-corruption measures reduce Chinese inflows. Even a shallow correction could hit consumption growth notably.”
Externally, Deutsche are also concerned about the potential for for a steeper slowdown in the Chinese economy in the second half of 2016.
“More worrying than slowing property inflows is the prospect of Chinese growth deteriorating markedly in H2,” suggests Deutsche.
“Slowing credit growth in China should also allow fundamentals to return to the fore in bulk commodity markets, where iron ore prices are likely to fall to a market-clearing $40 in H2.
“The poor terms-of-trade outlook is set to prolong the slump in mining investment, which has been the main drag on wage growth and core inflation,” it adds.
As a consequence of these risks, along with the still-elevated level of the Aussie in its opinion, Deutsche believes that the time is right to position for a significantly weaker Australian dollar moving forward.
The chart below suggests that the Aussie is the second most expensive currency in the world at present behind the Hong Kong dollar, in Deutsche’s opinion.
“We think entry levels are still attractive. The market has failed to fully price the magnitude of the currency adjustment Australia needs.”
As a result of this view, Deutsche suggests investors should position for broad-based Australian dollar weakness by selling it equally against the US dollar, Japanese yen and euro.
“We like selling the Aussie against G3 equally weighted to avoid undue exposure to an uncertain dollar/Fed outlook on the one hand and the TWI’s exposure to a peaky Asian EM complex on the other,” it says.
“We also like this narrow basket because, compared to AUD/USD, it has greater positive betas to Australia’s idiosyncratic terms of trade and rates, as well as to global risk sentiment.”