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

Monetary Policy Coordination: From Global Easing to Global ‘Tightening’

Abstract: An interesting series of central-bank announcements over the past semester confirmed my view of a global central banking monetary policy coordination. The first two major players that hinted in a speech that the central bank might slow down their asset purchases were the ECB and the BoJ; but more recently we heard hawkish comments coming from the BoC, RBA and even the BoE. In this article, I will first review the quantitative tightening (or the Fed balance sheet reduction program), followed by some comments on the current situation in the other major central banks combined with an FX analysis.

Link ==> US Dollar Analysis 2

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.

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.

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)

Markets after Yellen…

There have been some interesting developments for the past few days in the middle of this low-volatile environment. Firstly, Fed Chair Yellen opened two days of testimony on Capitol Hill yesterday, delivering the central bank’s semi-annual report to Congress. With the QE-Taper to end in October (already priced in), the market was waiting for more details concerning the ‘future path’ of the Fed Funds target rate (currently at a historical low of 0-0.25%). Despite strong employment data with Non-Farm Payrolls printing above the 200K level for the fifth month in a row in June (288K) and the jobless rate that edged down by another 0.2% to 6.1% (2008 levels), Yellen clearly stated that the US economic recovery ‘is not yet complete’ with the housing market showing ‘little progress’ but still disappointing this year.

However, she surprised the market a bit when she told the Senate Banking Committee that rates could rise sooner than planned. These comments ‘kind-of’ played in favour of the US Dollar, with USD index trading 80.50 at the moment. Its main component, the Euro (57.6%), broke out of his tight 1.3575 – 1.3675 range and is now trading at 1.3540 (see chart below). The next support on the downside stands at 1.3520, the 38.2% Fibonacci retracement of 1.2750 (July 2013 low) and 1.3992 (May 2014 high).

EUR-16-Jul

(Source: Reuters)

The second interesting development was the higher-than-expected CPI figures in UK that gave a boost to Cable after its last two weeks of weakening momentum. Annual inflation came in at 1.9% YoY in June (vs expectations of a 1.6% print), while CPI MoM increased by 0.2% (vs -0.1% consensus). It reinforced the market’s view that the BoE will be the first major central bank to lift rates. Even though some analysts are expecting a first move from UK policymakers later this year, I personally think that Q1 2015 sounds more reasonable. If we have a look at short-sterling interest rate futures, the March 2015 contracts sold off to 98.91 from 98.97, which means that the implied yield from 103bp to 109bp. Earlier this morning, UK claimant counts fell by 36.3K in June, following a revised 32.8K drop registered in May. The jobless rate edged down to 6.5% as expected.

After it reached a high of 1.7191 yesterday afternoon, Cable remains poised for a break above 1.7200 and is now trading at 1.7125. The first support on the downside stands at 1.7100, followed by 1.7060. A more interesting pair would be EUR/GBP, which is now trading at a 22-month low at 0.7900 and is approaching its next support at 0.7880 (see chart below).

EURGBP-16-Jul

(Source: Reuters)

Another surprise came from New Zealand where inflation accelerated less than expected, easing pressure on the RBNZ to continue its monetary policy tightening cycle. As a reminder, the central bank has increased its overnight cash rate (OCR) three times to 3.25% since the beginning of the year, and the market is still expecting a 25bps rate hike at the next meeting on July 23rd. I felt that the Kiwi strength would probably weigh on NZ policymakers’ decision at the next meeting, therefore I was expecting a correction on NZD (see my last trade short NZD/JPY). It was also interesting to play a technical bear correction on NZD/USD when the pair was flirting with its 3-year high as you can see it on the chart below.

NZD-16Jul

(Source: Reuters)

Quick update on BoJ and the Yen: USDJPY continues to trade sideways after the BoJ decided to keep its monetary policy unchanged (as expected), maintaining its target of increasing the monetary base at a annual pace of JPY60-70tr per year. The central bank cut its 2014 growth prediction to 1.0% (down from 1.1% last meeting and from 1.5% last October), but the board (9 members) unanimously maintained its inflation projection of 1.9% in the next fiscal year. If we have a quick look at the chart below, USDJPY is still trading within its tight 101.00 – 103.00 range. It found support slightly above the 101.00 level last week and seems on its way to test its next resistance at 101.94 (200-day SMA).

JPY-16-Jul

(Source: Reuters)

To finish, another currency AUDUSD that I have been trying to play lately is AUDUSD. The RBA minutes didn’t surprise the market on Tuesday despite AU policymakers’ willingness to see a lower Aussie (the minutes stated ‘the exchange rate remained high by historical standards’). I still think it is interesting to go short AUDUSD if the pair trades above 0.9400, with a medium term target at 0.9200 and a stop loss above 0.9560.

AUD-16Jul

(Souce: Reuters)

Events to watch this week…

1. The ECB meets on Thursday and we don’t expect much from policymakers despite low inflation and ECB M3 figures this morning. We saw that Flash inflation remained poor and steady in June (0.5% YoY), and ECB data on M3 Annual growth and Private Loan continue to disappoint. EURUSD recovered from its May losses and is now trading around 1.3650. The next resistance on the topside stands at 1.3672 (which corresponds to its 200-day SMA), followed by 1.3700. I would try to play the 1.3550 – 1.3670 range for the coming days, with a stop loss 50 Below/Above the range.

2. Tonight, the Reserve Bank of Australia is expected to keep its cash rate at a historical low level of 2.5%. I don’t see anything new; perhaps policymakers will try some more jawboning in order to push the Aussie down a bit. AUDUSD has remained pretty much rangy for the past few weeks, trading between 0.9330 and 0.9440. There seems to be a strong resistance zone at 0.9440/60 on the topside and it may be worth trying to sell some if the Aussie gets back to those levels for a test back towards 0.9330 (tight stop loss above 0.9480).

3. The Swedish Krona may continue to be under pressure this week ahead of the Riksbank meeting on July 3. The market is expecting the central bank to cut its benchmark rate by 25bps to 0.5% after CPI contracted by 0.2% YoY in May. Deflation is a drag and economists see it as a concern as it would only add to Sweden’s record household indebtedness. Even if the market is pretty bearish at the moment, I wouldn’t consider entering now as there is little room left. The SEK has depreciated 4.5% approximately against the Euro and the Dollar, and it may enter in an oversold area.