Forces gathering in bond and commodity markets could crush the Australian dollar

Photo: Cassie Trotter/ Getty Images.

The Australian dollar, one of the most resilient developed market currencies in the past year, could be facing its biggest challenge so far this century.

A resurgent US Federal Reserve and a cautious Reserve Bank of Australia (RBA) means the yield premium the South Pacific nation’s bonds offer over their US peers could vanish for the first time since 2000, while expectations for lower iron ore and coal prices could drag the currency lower too.

Investors see a one-in-two chance the Fed will deliver two more rate increases this year, while they expect the RBA to stay put at the current cash rate of 1.5%.

The yield spread that Australian debt offers over its developed market peers has been a key support for the local dollar, along with its status as a proxy for the Chinese economy and commodity prices. The directions of both aren’t conducive to continuing Australian dollar strength.

“We do put weight on the narrowing interest rate premium, but I’d place more emphasis on what happens to commodity prices,” said Paul Dales, chief Australia & New Zealand economist at Capital Economics. “As it happens, both these influences are pointing in the same direction.”

This chart shows the correlation between the Australia-US 10-year bond spread (right side) and the Australian currency against its US peer (left side).

IG, Bloomberg

Capital Economics expects the iron ore price to drop to about US$50 a tonne later this year. Iron ore has lost almost a third of its value since February, with Chinese Premier Li Keqiang signalling last month plans to cut steel capacity in the world’s second largest economy — Australia’s biggest trading partner.

Just today, iron ore futures went “limit down”, with trading halted after prices tanked more than 7% in early trade.

Combined with an inventory build-up at Chinese ports, iron spot prices have now fallen from above $U90 earlier this year to around $US68 per tonne. The view of many economists is for further falls.

Capital Economics also expects the Aussie interest rate premium to narrow as the US Fed hikes rates to over 1.5% this year. If that eventuates, the Australian dollar could weaken to US70c or lower, Dales said. The Aussie was at that level in late 2015 and early 2016 on fears of a Chinese economic slowdown.

The Aussie was buying around US74.2 cents on May 4. It lost plenty of ground overnight, as commodity prices fell (copper crashed by 4.5%) and the US dollar rose after a relatively positive outlook by the US Federal Reserve at its interest rate announcement.

Despite the fall, the Aussie is the third-best performer in a basket of the group of 10 currencies so far this year, beaten only by the pound and yen. The median estimate of analysts in a Bloomberg survey is for the Aussie to end the year at US74c, with estimates ranging from US70c to US81c.

A couple of factors could save the blushes for the Aussie.

Firstly, investors are likely still net long on the US currency, which indicates they expect the greenback to rise further, and a change in sentiment could support the Aussie, according to Nomura’s Australia interest rate strategist Andrew Ticehurst.

Nomura expects the AUD to end the year around US76c to US77c with weakening commodity prices and narrowing yield spreads offsetting a reversal in US dollar bullishness, he said.

Secondly, the Australian dollar hasn’t reacted to the spike and recent reversal of the iron price, leading to a divergence since late last year.

That is because investors are probably thinking the increase in iron prices was unlikely to spur further mining investment or exports in later years, according to Chris Weston, chief market strategist at IG Ltd.

The following chart shows the breakdown in the correlation between the Australian dollar (left side) and commodity prices (right side) over the past few months:

IG, Bloomberg

The Australian dollar’s moves against the US currency have typically tracked the bond yield differentials. The last time the yield premium was non-existent was in 2000 when US and Australian official interest rates were very close. At that time, the Australian dollar was trading at between 50 and 60 US cents:

Reuters

Since then the spread has diverged, earning the Australian dollar the high-yield currency moniker that triggered foreign buying of Australian government bonds, which in turn boosted the currency.

The Aussie-US. spread was more than 2 percentage points in 2012 when the proportion of foreign ownership peaked at 76% amid a hunt for yield and diversification by reserve managers. The Aussie hit a record high of US$1.10 in 2011 also spurred on by the commodities boom.

Since then sliding commodity prices and an uptick in bond supply as the government struggled to rein in a budget deficit has seen the ratio of foreign ownership ebb to the lowest level in almost a decade.

Australian benchmark 10-year bonds today offered a premium of 33 basis points over their US peers.

“The variables that support the Aussie including commodity prices are moving against it”, Nomura’s Ticehurst said.

“That could exert downward pressure on the currency. While it may hold up against the US dollar in the coming months we expect it to weaken against the crosses particularly against the euro,” which Nomura expects to gain from the central bank tapering and improving economic prospects.

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