The History of the Australian Dollar (Aussie)

In today’s article, we continue our series on the History of Currencies, with a particular focus on the popular carry-trade currency: the Australian Dollar. According to the BIS Foreign Exchange Turnover, the Aussie stands at the 5th position (straight after the British pound) in terms of volume with a daily average of 348 billion US Dollars (which represents 6.9% in percentage shares of average daily turnover).

This article is organized as follows. In the first section, we quickly introduce some important historical events for Australia and its currency. In section 2, we explain the trends and reversals of the Australian Dollar (versus. USD) since the end of the Bretton Woods system in addition to stating the main potential drivers of the currency pair. In Section 3, we quickly present a few [practical] charts using the Aussie for our case study.

I. Important events in Australia and the history of the Aussie until the end of the Bretton Wood System (1971)

A. Origins and History

From being the land of the indigenous Australians (60,000 years ago) to becoming a Federal Constitution on January 1st 1901, Australia attracted the interest of many conquerors. But the two main European explorers were the Dutch (Willem Janszoon, 1606) and the British (James Cook, 1770).

Despite the first European settlement taking pace in the late 1788 at Port Jackson in New South Wales (Sydney today), the latter colony experienced money shortage for the next three decades as the British [Empire] was challenged by France under Napoleon, investing large amounts of capital and resources to win. Hence, the mean of exchange (what today could be called ‘Store of Value’ or ‘Reserves’) during that period was Rum.

Then, the first coinage issuance happened in 1813, after Lachlan Macquarie (Governor of New South Wales) took the initiative of using 10,000 British pounds worth of Spanish Dollars received by the British government. The plan, that took a year to complete, was to convert the 40 thousand imported coins to 39,910 holey dollars (coins with a hole inside) and 39,910 dumps. Then, in 1817, the Bank of New South Wales (first bank in Australia) was established to provide economic stability for the citizens of the state, and started to issue paper currency.

Eventually, Sterling coinage was introduced in 1825 in all British colonies as a result of the Coinage Act 1816 (British Gold Standard) and the decline in the supply in Spanish dollars due to Latin American wars of independence, and the Holey dollar went out of circulation in the late 1820s (no longer legal tender in 1829). Due to a large increase in the population, and a rejection from Britain to the requests from Australian colonies to make gold coins, unofficial gold coins were used during the Victorian gold rush of the 1850s. Then, in 1855, Australia’s first official mint was established in Sydney, and started to produce gold coins called sovereigns (worth 1£), half sovereign and private bank notes.

B. Australian Pound, Gold Standard and WWI

After the Federation in 1901, Australia started to prepare for a national currency as the government started to realize the importance of a stable currency regime. Hence, in 1910, the Australian pound was born, consisting of 20 shillings. As the Australian pound was pegged to the British pound, Australia was therefore on a Gold Standard. If we look at the bilateral exchange rate against the US Dollar, we know from Figure 1 that the British Pound was roughly worth 5 units of USD, hence the USD/AUD exchange rate at that time was fixed at $5.

In 1914, Britain temporally exited from the Gold Standard as a consequence of WWI, creating inflation pressures, but returned to it in 1925 at the parity. As the exchange rates (both the British and Australian Pound) devaluated during and after the War, the sharp revaluation of the two currencies reduced exports drastically and raised deflationary waves resulting in both an increase in the unemployment rate and a contraction in productivity (See Australia Terms of Trade history in Figure 2 (Gillitzer and Kearns, 2005)).

Australia left the Gold Standard in 1929 due to the Great Depression and started a series of devaluation against the Sterling pound. All we know is that in December 1931, a Sterling pound was then worth 1.5 Australian pound. Between 1929 and 1932, the sharp contraction of the terms of trade as a result of a fall in commodity prices severely impacted the Australian economy. The unemployment rate soared to over 20 percent in the early 1930s (Figure 4), leaving hundreds of thousands of Australians out of work, and the country’s national income declined by 30 percent.

The devaluation of the currency and the improvement of major trading partners’ economies (United Kingdom and US) led to a slow recovery, with improvement in the Balance of Payment and an unemployment rate slowly converging to its long-term mean (5 percent) thanks to an explosion in the manufacturing sector.

C. World War II and Bretton Woods period

As we described in our article History of the British Pound, an agreement between the US and UK pegged the Sterling pound to the US Dollar at a rate of $4.03 in 1940. That exchange rate remained fixed after the start of Bretton Woods agreement in 1944, but UK Chancellor of the Exchequer Sir Stafford Cripps announced a 30-percent devaluation from $4.03 to $2.80 in September 1949. At the same time, Australian Prime Minister Ben Chifley followed the British move and devalued the Australian pound from $3.224 to $2.24 in order to not experience an over-valued currency relative to its Sterling zone countries. That means during all that period (before and after the devaluation), the Australian pound was worth 1.25 per unit of Sterling pound.

D. The Birth of the Australian Dollar (and the RBA)

After several names suggestions for the currency (i.e. royal, austral, koala, digger…), the Australian pound was eventually replaced by the Australian Dollar in 1966 (February 14th), almost 6 years after the establishment of the Reserve Bank of Australia (i.e. Australia’s current central bank). The rate of conversion was set at two [Australian] dollars per unit of Australian pound, which means that the Australian Dollar was worth US $1.12. The UK government of Wilson announcement of a 14-percent Sterling depreciation against the US Dollar (from $2.80 to $2.40, see figure 1) didn’t impact the Australian Dollar, which rate remained pegged to the US Dollar at a rate of $1.12.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon Shock and the Smithsonian Agreements (1971 – 1973)

After the Nixon Shock in August 1971, the Australian Dollar was revalued several times against the US Dollar, from its starting point at $1.12 to a historical high of $1.488 in 1974. Unlike many countries that decided to let their currency float at the end of the Smithsonian Agreements in February 1973, Australia tried to keep its exchange rate fixed (against the greenback).

B. 1974 – 1986: A Decade of Depreciation

The deterioration of the terms of trade in the mid-1970s (See Figure 2), coming from a change in economic circumstances in addition to a strong exchange rate (even versus booming economies such as Japan and Germany), led to a series of exchange rate devaluations. The first one occurred in September 1974, when the Australian Dollar was devalued by 12 percent to $1.31. The second one happened in November 1976 when the Government decided to devalue the currency by 17.5 percent, and the Aussie reached a low of $1.0160 after that announcement. The pair consolidated in the late 1970s and early 1980s to reach a high of $1.19 in January 1981, thanks to an investment boom in 1980 and 1981 following the 2nd oil shock in 1979. However, the recession that hit most the OECD countries in the early 1980s (due to the Oil Shock) reduced drastically the demand for Australia’s minerals and energy, and the inflationary pressures generated by the wage explosion of 1981-1982, both led to a perception that the Australian Dollar was starting to be overvalued. The Australian Dollar then started a two-year depreciation against the greenback, and ended its fixed regime area by a 10 percent devaluation in March 1983, when PM Bob Hawke came to power and announcement the third big depreciation in hope of spurring the export sector.

C. 12 December 1983: From a Crawling Peg to a Floating Regime

In March 1983, one unit of Australian Dollar was worth roughly 85 cents of US Dollar. The exchange rate again consolidated until the end of the year and in December 1983, the Aussie Dollar was floated and foreign exchange controls were dismantled [during the night on December 12].

In the last few years before moving to a floating regime, the Australian Dollar was pegged to the Trade Weight Index (see computation of the TWI Index in Table 1) and the value of the exchange rate was determined each day by the RBA in consultation with the government. The reason of the float move was mainly to improve the efficiency of the financial system, in addition to providing the authorities better control over domestic monetary policy (Blundell-Wignall et al., 1993).

The change in the policy resulted in a sharp appreciation of the volatility of the Australian Dollar [both bilateral exchange rate and TWI], adding pressure on the commodity currency. The exchange rate experienced significant losses against the US Dollar, reaching a low of $0.5960 in August 1986.

D. 1986 – 1989: The Aussie Strength

When it comes to Australia, the terms of trade has always been one of the fundamental drivers of the exchange rate, which is strongly correlated to commodity prices. As a result of a 50 percent increase in commodity prices between 1986 and 1989 (due to a strong increase in the world’s demand), Australia terms of trade increased from 52 in Q3 1987 to 63 in Q3 1989, hence pushing up the exchange rate USD/AUD from $0.5960 to $0.8960. During that period, Australia was experiencing an investment ‘boom’, a strong business confidence and rising national savings. Concerned about the sustainability of this economic ‘boom’ and RBA policymakers started to run a tightening monetary policy as a response to ‘deflate’ the asset price inflation wave.

E. 1990s: Weak global demand, low commodity prices and the Aussie depreciation

The US recession in the early 1990s, Japan’s beginning of the deflationary deleveraging decade in addition to the 1990s Financial Crises in Nordic Countries have decelerated global demand, impacting commodity prices and therefore shrinking Australia’s term of Trade. According to the Bloomberg Commodity Index (BCOM), commodity prices fell 42 percent between Q2 1997 and Q2 1999 (chart 2). During that same period, the Aussie depreciated by roughly 20 cents against the US Dollar, dropping from $0.80 to $0.60.

F. 1998 – 2002: The Dollar appreciation (Aussie Weakness)

As we discussed in our previous articles on FX history, the turn of the millennium was expressed by a US Dollar strength against the major currencies (we saw it with the Euro, Sterling pound and the Yen). The second part of the 1990s was characterized by the famous Clinton Dollar rally, where the USD index increased from 80 in early 1995 to 120 in early 2002 on the back of significant productivity gains, budget surpluses and capital inflows in the equity market (and especially tech stocks).

During that period, USD/AUD went down from $0.65 to hit a historical low of $0.48 in late 2001.

 G. 2002 – 2008: Global Demand and Super Cycle

The emergence of China (and other emerging market economies known as the BRICs) at the turn of the millennium led to a sharp unanticipated increase in commodity prices (see chart 2, Super Cycle), with the BCOM Index rising from the low 90s in early 2002 to almost 240 in July 2008, which resulted in a levitation of all commodity currencies. The Australian Dollar increased from its record low of $0.48 to $0.9850, more than doubling its value during those 6 years. If we look at the chart of the USD/AUD overlaid with the BCOM index (chart 2), we clearly an important correlation between the currency pair and commodity prices.

In a recent publication, Ferraro, Rogoff and Rossi (2015) showed that there exists a relationship between changes in the price of a country’s major commodity export price and changes in the nominal bilateral exchange rate for short frequency time series (daily data).

During that period, investors were also chasing the carry trade strategy, one of the most popular strategy in FX, where a typical trade would involve borrowing the currency with the lowest interest rate (such as the Japanese Yen) and investing in the currency with the highest interest rate (i.e. Australian or New Zealand Dollar).

H. July – December 2008: Risk-Off, Carry Unwinds and Aussie Crash

In the second semester of 2008, the Aussie experienced significant depreciations against the safe-heaven currencies, such as the US Dollar, the Japanese Yen and the Euro. For instance, between July and October 2008, USD/AUD went plummeted from $0.985 to 60 cents ($); more surprisingly, the Aussie depreciated almost 50 percent against the Yen, JPY/AUD went down from 104.50 to 55 during the same period.

We will talk more about the potential explanations behind the crash in our case study (Section 3), but one important thing to understand is that investors typically look at the Aussie as a risk-on asset and the currency tends to be highly correlated with equities in general. Hence, when economies plunge into recessions, equities typically fall, and so the Aussie (Chart 4).

I. 2009 – 2013: Commodity recovery and an overvalued Aussie

In reaction to the Financial Crisis, central banks lowered their interest rates down to record levels (zero bounds) and started a series of outstanding purchases of assets (QE). The recovery was immediate in commodity prices (Oil surged from 40 in 2009 to over 110 in 2011), which was one of the key drivers of the Aussie strength during that period. Note that Australia is perceived as an export driven economy: according to the World Bank, it exports totalled $190bn in 2015, with Iron Ore ($37.5bn) and Coal ($30.2bn) being the top-2 earners, with China ($62.3bn) and Japan ($$30.7bn) accounting for roughly 50 percent of the exports (see Picture 1).

Australia is also the beneficiary of a ‘double Chinese dividend’. In addition to export goods and commodities to the giant China, the shiny coasts are trending destinations for Chinese tourists. Hence, we can state that this after-crisis period was saved by Chinese demand.

On the top of that, Australia was offering a higher interest rate that developed economies; the cash rate in 2012 was 3.5%, while it was 75bps, 50bps and 0bps in Europe, UK and US respectively. It was also the only economy not to fall into a recession after the Financial Crisis in 2008, and is one of the few countries left with a triple-A rating. One interesting fact about Australia is that the last recession happened in 1991, and the country is on its way to surpass the Netherlands and its 26 consecutive year of economic growth (between 1982 and 2008).

The problem (or the curse) of all export-driven economies in periods of booms is how to deal with a strengthening currency. Thanks to its mining industry (primary industry and contributor of the country’s economy), Australia has experienced several episodes of mining boom in its history, bringing interest of foreign investors in both the country’s assets and currency, which tend to result in a currency appreciation. A mining boom resulting in a real exchange rate appreciation is what economists have called the ‘Dutch Disease’ as a persistent strong currency tends to have a negative effect on exports and various import-competing industries.

Therefore, when the Australian Dollar started to trade above parity against the greenback, there were many talks of an overvalued currency, from 20 to 30 percent above its historical mean according to some economic models.

J. May 2013 and beyond: QE Taper, End of the Super-Cycle and the Freefall of the Aussie

 On May 22 2013, the announcement of a potential “QE Taper” by Fed chairman Ben Bernanke triggered a sudden spike in volatility, with an aggressive sell-off in the emerging market. As a reminder, the Fed had been on a $85bn monthly purchase program since December 2012 at that time. Hence, the sudden comments from US policymakers created a little panic in the market that we now refer as the Taper Tantrum. Della Corte, Riddiough and Sarno (2016) worked on global imbalances and currency prermia, showing that debtor countries issue riskier currencies and offer a [currency] risk premium to compensate the risk in high periods of volatility.

Following those comments, the Aussie Dollar experience a 16 percent devaluation between May and September 2013, which was the start of a bear trend in the commodity currency. The fall in commodity prices in 2014, which analysts called ‘the end of the commodity super-cycle’, in addition to the 2014 Dollar rise and lower expected growth rates printed by China, pushed down the Aussie to a low of $0.68 in the beginning of 2016 (the same time when the front-month WTI oil contract was trading at $26 per barrel).

Since then, USD/AUD experience a consolidation, up north 10 cents mainly due to a US Dollar weakness over the past 7 months. As you can see on Chart 3, commodity prices have been steady over the past with Oil (WTI) trading at mid-40s.

III. Case study: The Aussie and the Carry Trade

The carry trade is one of the most popular strategies in the currency market, and simply consists in borrowing the currency with the lowest yield (i.e. the Yen) and invest in the currency with the highest yield (i.e. the Aussie). Chart 4 represents the JPY/AUD spot rate overlaid with the SP500 Index between 2002 and 2012. As you can see, the carry strategy during all that period was heavily correlated to equities, which tells you that you should treat carry trade currencies like a risk-on asset (i.e. equity), and that risk-on assets [all] tend to do bad in periods of rising volatility (i.e. VIX). Hence, a traditional long-equity investor who thought he was diversified by holding a carry trade portfolio experienced significant drawdowns during the financial crisis. The SP500 Index plummeted from 1,300 to 800 when the JPY/AUD exchange rate fell almost 50 percent in the summer 2008.

There is a vast amount of literature on carry trade and currency crashes; for instance, Brunnermeier, Nagel and Pedersen (2009) showed that carry trade strategies are negatively skewed, and that this skewness is due to sudden positions unwinding (carry traders are usually very leveraged). Hence, we now say that carry trade strategies ‘go up by the stairs and down by the elevator’.

In my opinion, the JPY/AUD chart is one of the (if not the) most important chart in Finance, and especially for short-term investors like myself. Every morning, I start my day with a coffee in front of the JPY/AUD, to see if something happened overnight. In Chart 5, I plotted a 5-minute history data of the JPY/AUD (black line) overlaid with the SP500 index (purple line). We can clearly see that a higher JPY/AUD is usually accompanied by a higher stock market; a sort of Pavlovian response of Cheaper Currency = Higher Equities. Hence, an positive overnight momentum on the Aussie Yen (i.e. Yen depreciation) is a good signal for the economy, and can be usually translated by ‘nothing serious happened in Asia’ (either China, Japan or Australia). However, a strong  Japanese Yen appreciation, like the one on August 28th / 29th in our chart, isn’t usually representative of a positive signal in the market, and equities tend to be red in Asia, Europe and US usually. My typical reaction would be to see what happened in Asia. This time, the Yen Strength was due to the headline of North Korea firing ballistic missile over Japan. Big {negative] overnight moves are usually link to disappointing Bank of Japan meetings, Australia lowering interest rates or a Chinese Yuan sudden devaluation.

Chart 1. USD/AUD exchange rate history (Source: Reuters)

AussieHist

Chart 2. USD/AUD spot rate (candlesticks) and the BCOM Index (line) (Source: Reuters)AussieBCOM

Chart 3. USD/AUD spot rate (black line) and the Oil prices (WTI, red line) (Source: Reuters)

AussieOil.PNG

Chart 4. JPY/AUD spot rate (candlesticks) and the SP500 Index (red line) (Source: Reuters)AussieSPX.PNG

Chart 5. JPY/AUD (5-min) spot rate (black line) and the SP500 Index (purple line) (Source: Reuters)AUDJPY.PNG

Figure 1. USD/GBP exchange rate since 1971 (Source: Bank of England)

GBP.PNG

Figure 2. Australia Terms of Trade History and Real TWI (Source: Gillitzer and Kearns, 2005)

Picture 1. Aussie Exports for 2015 (Source: OEC)Aussie Exports.PNG

FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore I think it is a good time to share my current FX positioning.

Fed’s meeting: hike or no-hike?

I think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

CME.png

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. I strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

ISM_US.JPG

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. I would stay short USDJPY as I don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

USDJPY.JPG

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). I don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore I don’t think we will see a lot of volatility in the coming days. I wouldn’t take an important position in the Euro, however I can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

eur

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. I would try to short some as I think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

I would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, my analysis stands close to the Yen’s one, and therefore I think the Swiss Franc strength could continue in the coming days. I like 0.96 as a first ‘shy’ target, and I would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Australia.png

(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). I don’t see any volatility rising in the next few weeks, therefore I wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, I think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

Quick Macro update: China and Commodities

  1. China continues to shake the markets

The first chart that I want to start this analysis is the Shanghai CSI 300 Index (see below), down 40% since its previous high (5,380) reached on June 9th 2015. As you know, news from China has been the major ‘driver’ of the financial market, giving a harsh time for European and US fund managers. The index is approaching the psychological support of 3,000 and its August low of 2,952, two critical levels for the Chinese economy.

CSIdex

(Source: Bloomberg)

The volatility in China (which will affect global markets overall) is coming from its too-leverage banking system, which I believe cannot survive if we enter a Bear market in the EM world. As Kyle Bass from Hayman Capital reported in his late interviews, China bank assets totalled 31tr USD in 2015, up from 5tr USD in 2006 if we look at the chart below. If we express it as a share of the country’s GDP (roughly 10tr USD), the banking system (total assets) is 350%.

ChinaBanks.jpg

(Source: Hayman Capital)

The consequence of a [sharp] decline in equity and property markets will lead to a constant surge in NPLs in the medium term, therefore putting the whole banking system into huge troubles.  Housing starts have fallen by almost 20% in 2015 (based on an average estimates) and the excess of inventory unsold properties have surged dramatically (Standard Chartered estimates the number at 9 million, with a further 40m to 50m homes being held vacant as investments). This is clearly problematic as it is widely known that China’s household wealth is mostly concentrated in housing, which account for 15% of the country’s GDP. To give you an idea, the 2003-08 housing market in the US represented barely 5% of the US GDP.

I believe that China is poised to print constantly lower-than-expected GDP growth rates due to this instability, therefore being the main risk factor for global markets in 2016 (Q4 GDP came in at 6.8% QoQ vs. 6.9% est.). One interesting chart to look at this year is the USDCNH – USDCNY spread analysis. Since the PBoC devaluation, we can see that spread off the offshore/onshore currencies has been very volatile, moving up to 1400 pips (i.e. USDCNH was trading at 1400 pips above USDCNY).

CNYsp.jpg

(Source: Bloomberg)

2. Commodities update: where is the low? 

As I gave a quick [bearish] review on China, I have to give an update on commodities, which are still trying to find a new low. As you can see it in the chart below, the Bloomberg Commodity Index (BCOM) broke below its March-99 low of 74.24 yesterday and is down almost 70% since its July 2008 high. I wouldn’t see this new low as a buying opportunity as long as I don’t visualize any upside coming from the EM economies.

BCOM.gif

(Source: Bloomberg)

The end of this commodity super-cycle is dramatically hurting many energy companies, and corporate default is clearly becoming the biggest financial threat for this year. For instance, Glencore 2021 and Noble 2018 bond price recently plummeted to new lows yesterday, trading at 64.4 and 56 cents on the par and increasing the probability of bankruptcy.

3. The death of the commodity currencies… 

This commodity meltdown has sent the Aussie (candles) to (almost) a seven-year low against the dollar, trading at 69 cents against the dollar, and the USDCAD (yellow line) has reached a 12.5-year low and is currently trading at 1.4530, down 25% in a single year. I will always remember Stanley Druckenmiller words from the Ira Sohn Conference in May 2013 when he talked about the Commodities Conundrum. He said he was betting that it was the end of the ‘supercycle’ for commodities (referring commodity currencies as ‘dead’) and he was already warning of a potential financial crisis in China. I have to admit that I would never have imagined such a drawdown; however, today I am still thinking there is potential downside risks.

AudCad.jpg

(Source: Bloomberg)

Just to let you know, this article is just a quick-start of a series of more detailed analysis of economic areas (Japan, US and Euro), coming up in the next couple of weeks.

Japan, the Yen and the Aussie

Three days ago, we saw that Japanese GDP contraction in the second quarter was revised to an annualized 7.1% QoQ (vs. 6.8% previously), shrinking at its fastest pace in more than five years, due to a deeper decline in consumer spending and a bigger fall in capital expenditure (money used to purchase, upgrade, improve or extend the life of LT assets). In addition, the Ministry of Finance reported that the country showed market a current account surplus of 416.7bn Yen in July (slightly less that 444bn expected and 30% down compare to July last year) as the income from foreign investments (up 2.8% to 1.853tr Yen) outweighed the trade deficit (964bn deficit Yen in July, August one to be released on Sep 17th).

While the unemployment has fallen quite sharply since Abe’s election (4.5% in Dec 2012) to 3.8% in August, real wages have constantly been declining over the past few years (they fell by 3.8% YoY in May, the sharpest decline in years). One explanation of the fall in real wages I read lately (The Economist, Feeling the pinch) was that Japan’s labour market is divided between two sorts of employees, regular ones who are usually highly paid and protected [against being fired] and the non-regular [low-paid] ones. If you have a look at the figures, non-regular workers accounted for 36.8% of all jobs in June, a high number compare to historical standards and therefore confirming that most jobs created since Abe took office were non-regular workers.

This definitely explains weakening figures in household spending. We saw that July Household Spending fell 5.9% YoY, twice what economists expected, printing in the negative territory for the fourth time in a row. As a reminder, Japan is a consumer-driven economy (61% as a percentage of GDP in 2012 according to the World Bank); therefore the BoJ will watch closely those figures in order to avoid another dismal quarter.

However, according to the Bank of Japan Deputy Governor Kikuo Iwata, the economy is ‘gradually recovering’ and it is all about the sales tax increase effect. Moreover, with the BoJ now monetizing debt at negative rates (T-Bill 12/08/2014 has been trading in the negative territory for the past few days as you can see it in the chart below), Iwata added that he didn’t see ‘any difficulties in money market operations’.

sg2014091052862(1)

(Source: Bloomberg)

Quick review on USD/JPY

The recent surge in the stock market (Nikkei up 1,000 pts over the past month, closing at 15,788.78 earlier this morning) mainly coming from ‘more QE coming soon’ speculation combined with demand for international securities (Bonds, Stock) from Japanese funds have both played in favour of the depreciation of the Yen lately since it broke out of its 101 – 103 range on August 20. In addition, with US yields starting to ‘surge’ (10-year yield up 20bps over the past two weeks and now trading at 2.53%), USDJPY was sent up to 106.85 during today’s trading session, breaking its resistance of 105.44 (Jan 2nd high) and trading to levels seen back in September 2008. If the depreciation continues, the next MT target on the pair stands at 110.

Aussie updates…

AUDJPY (black bar) eased a bit from last week’s [16-month] high of 98.65, down more than a 100 pips (carry trade unwinds combined with AUD selling from corporate and macro names), taking the equity market (red line) with ‘him’ (S&P closed below the 2,000 level at 1,988).

AUDJPY-10-Sep(1)

(Source: Reuters)

The AU benchmark (S&P/ASX) index came back to a 3-1/2 week low after Westpac’s index of consumer sentiment reported a 4.6% decline in September, bringing the Aussie below the 0.9200 support against the greenback.

AUDUSD is also trading below its 200-day MA (0.9180) for the first time in five months. Market has turned bearish on the pair as the failure to hold the 0.9180 – 0.9200 support area has opened up further retracements levels: 0.9075 (61.8% Fibo retracement of 0.8658 – 0.9756), followed by 0.9030. Australia will report employment figures overnight (2.30 am), which traders expect to be disappointing, therefore sending the Aussie to lower levels.

AUD-10-Sep(1)

(Source: Reuters)

The JPY and some overnight developments…

The last development that I found interesting lately was certainly USDJPY breaking out of its [four-month] 101 – 103 range on August 20. Despite US LT yields trending lower (10-year trading below 2.40%) and the BoJ showing no interest of increasing QE even though the economy printed dismal figures (except a strong CPI), the Yen has weakened by almost two figures in the past couple of weeks against the greenback and is now trading slightly below 105.

I was a bit surprised by this breakout as I thought until lately that the JPY had no reason to depreciate against the US Dollar (especially with a quiet BoJ and US LT yields expected to remain low in H2 according to analysts). My thoughts was that the Yen depreciation mainly came from the carry trade positions (‘risk-on’ sentiment) with AUDJPY trading at new highs at around 97.50 (which corresponds to June 2013 levels), and I first assumed that the risk-on situation isn’t fully established and the market was just looking for ST opportunities and that any major ‘bad’ news could potentially trigger some massive carry unwinds as we saw previously (aka Yen appreciation).

However, after a few chats with some FX strategists (who I all thank for their kind answers), a first important thing to notice is the decrease in the 6-month (daily) rolling correlation between AUDJPY and S&P500 from 67% back in mid-February this year down to 47% today. In other words, the Japanese Yen sensitivity to risk-off moves has fallen as you can see it below in the Bloomberg Spread Analysis.Audcorr

(Source: Bloomberg)

Secondly, traders and investors are becoming more confident on a BoJ move later on this year, and further easing by JP policymakers (after Japan dismal figures: July household spending collapsed 5.9% YoY, Q2 GDP shrank by annualized 6.8% erasing Q1 gains, Housing starts down 14.1% in July…) is the main driver on Yen weakness according to analysts.

Eventually, another factor to look at would be Japanese institutional investors switching from bonds to stocks (and international stocks and bonds); we saw strong demand for French OAT from Japan last week. For instance, as you can see it below, GPIF, Japanese 1.2-trillion-dollar retirement fund, reduced its domestic bonds holdings by almost 10 percent in the past 3 years and has gradually increased its holdings of Japanese equities and International Bonds and Stocks. In June this year, it reported that it held 53.36% of domestic bonds and 17.26% of domestic stocks, down from 62.64% and 12.37% respectively back in 2011 (Abe’s effect). As a reminder, GPIF has a 60% target for domestic bonds and 12% for Japanese stocks, with 8% and 6% deviation limits respectively for those assets.

Gpif

Having said that, the 105 level could potentially act as a psychological resistance at the moment, next important level on the topside stands at 105.44, which corresponds to January 2nd high. USDJPY looks a bit overbought as you can see it on the chart below, and I will look for lower levels to start considering buying some more.

JPY-2-Sep(1)

(Source: Reuters)

Aussie pausing as I expected…

The late US Dollar rally (USD index flirting with 83.00, its highest level since July 2013) hasn’t impact the Aussie (that much) and AUDUSD is still trading within its 5-month 0.92 – 0.95 range. The RBA left its cash rate steady at 2.50% (as expected) and looks unlikely to change it for some time, which is what I was assuming (see my article RBA is giving up…). The BBSW rates, which correspond to transparent rates for the pricing and revaluation of privately negotiated bilateral Australian dollar interest swap transactions, are trading quite flat with the 1-month and 6-month bills paying 2.66% and 2.69% respectively.

Despite AU annual inflation approaching the high of the RBA [2-3] percent inflation target range (Trimmed mean CPI came in at 2.9% YoY in the second quarter), AU policymakers noted slack in the job market and rising house prices.

The trend on AUDUSD looks bearish at the moment; I will try to sell some if the pair pops back above 0.9300 ahead of US employment reports on Friday. I’d put an entry level at 0.9330, with a tight stop loss at 0.9360 and a target at 0.9210.

Figures to watch this week:

AU GDP YoY (sep. 3rd): expected to ease back to 3.0% in the second quarter, down from 3.5%.
AU Trade balance (Sep 4th): expected to come in a -1.51bn AUD in July.
US Non-Farm Payrolls (Sep 5th):  expected to print at 225K in August, above the 200K level for the for the seventh consecutive month.

Recovery mode after market turbulence

Markets have been pretty shy this week, with equities recovering after two weeks of ‘correction’.
The S&P500 found support slightly above the 1,900 level on Friday after a 4.35% decline since July 24 high of 1,991.39. Market sentiment worsened as Obama launched another Iraq Assault, with traders potentially willing to put on some bearish positions; however it seems to me that markets don’t seem to be able to handle increasing risk well. AUDJPY eased 150 pips to find support at 94.40, which means that we reached our target of 94.60 based on our previous trade recommendation (see here).

AUDSP(2)

(Source: Reuters)

Another sharp move was in the German market with the benchmark DAX index (blue line) off more than 11% between July 2 high (10,032.28) and last Friday’s low of 8,903.49. If you add the French and UK benchmark indexes (FTSE100 in red and CAC40 in orange), you can see that they had approximately the same path (see graph below), both down 4.3% and 7.5% respectively.

Equities(1)

(Source: Reuters)

The single currency remains under pressure after last week equities sell-off and disappointing fundamentals. EURUSD is trading at a 9-month low, slightly below the 1.3350 level, after German ZEW survey came in well below expectations yesterday as geopolitical tensions and the sluggish recovery weigh on the European’s largest economy. Russia is one of Germany’s main trading partners, therefore there are signs that the German economy will grow at a lower rate than expected in 2014. As a reminder, final Q1 GDP came in at 0.8%; growth is expected to be flat on Q2 according to analysts’ first estimates.

 

Traders will watch EZ Q2 GDP first estimate and the final July CPI tomorrow, which are expected to come in at 0.1% QoQ and 0.4% YoY respectively. I am still bearish on EURJPY (entered at 137.20 with a MT target at 134.10), mainly based on a Euro weakness (ECB easing in addition to poor fundamentals).

 

Yen: The BoJ two-day meeting didn’t change any forecast on USDJPY, and the pair is still stuck within its 101-103 range for the past four months (couple of exceptions). Equities sell-off (Nikkei index down 1,000 pts between July 31 and Aug 8) combined with low US yields (10-year bottomed at 2.35% on Friday and is now trading slightly above the 2.40% level) played in favour of the JPY. USDJPY was sold to 101.50 on Friday and is now trading in the middle of its 200-range. Last night, we saw that Japan Q2 GDP collapsed by 6.8% according to Japan’s Cabinet Office (slightly less than the 7.1% expected), its worst contraction since 2011. While inventories additions added 1.0% growth, consumer spending fell 5.2% QoQ after the nation increased its sales tax from 5 to 8 percent on April 1st. I will get back to Japan this week with an article focused on its economy outlook and what are BoJ policymakers’ options.

Fighting against the Aussie…

An interesting development overnight was the Australian Q2 inflation data which is approaching the higher band of the 2-3% RBA target range. Australia’s trimmed mean CPI, the indicator the RBA officials look at which excludes volatile items that are included in CPI, rose from 2.6% to 2.9% in the second quarter (expected at 2.7%). The news lifted the Aussie to 0.9450 against the greenback as it slowed down the market’s expectations of another rate cut further this year.

AUDUSD started to recover from its last-week ‘losses’ after RBA Governor Stevens didn’t mention anything about the exchange rate overvaluation at a charity lunch in Sydney on Tuesday. As you can see it on the chart below, the increase in the 2-year AU-US yield spread (in blue) has pushed AUDUSD (yellow bars) to higher levels and the pair is now flirting with its resistance at 0.9460. A breach of that level could easily bring us to the next resistance area 0.9475 – 0.9500 (which corresponds to levels we saw in the beginning of the month).
I remain bearish on the Aussie and I think that a bounce back above 0.9500 could be another interesting level to start shorting the pair with a stop loss above 0.9560. My medium term target remains at 0.9200.

AUD-Spread

(Source: Reuters)

Another graph that I like to watch is AUDJPY. As you can see, the pair is approaching its first strong resistance at 96.00 (currently trading at 95.90). It seems that the market has been rejecting AUDJPY above this level over the pas few months, and for those who are not convinced on the AUDUSD trade, it could be also interesting to enter a short position on AUDJPY at current levels, with a stop loss above 96.60 and a first target at 94.60.

AUDJPY-23Juy

(Source: Reuters)