AUSTRALIAN DOLLAR DEVELOPS AN IMAGE PROBLEM - ANZ Bank research

AUD DEVELOPS AN IMAGE PROBLEM

• With the RBA ( Reserve Bank of Australia ) back in play, domestic factors will once again become a critical element in determining the direction of the AUD.
• The impact of domestic factors on the AUD will be greater than the sum of their parts as Australia starts to suffer from an image problem.
• We downgrade our AUD forecasts for the end of 2015 from USD0.82 to USD0.74, and for the end of 2016 from USD0.80 to USD0.72. We also reassess our view on AUD/NZD and expect it to remain range bound around these historic lows.
  Overall, relative to last year, we think that the nuance around currency valuation dynamics will change and the question that will need to be raised is whether this is the year that the AUD undershoots fair value, and provides a net boost to the economy.
  We also think that the domestic economy will become a more important swing factor in the level of the currency this year as the RBA comes back into play after more than 12 months on the sideline.
  SHORT-TERM DYNAMICS SUGGEST THAT THE AUD IS FAIR, BUT FUNDAMENTAL SHIFTS CANNOT BE IGNORED
  Over both very short and medium-term time frames the AUD looks like it is trading at a level that aligns with model estimates.
  A more medium-term, static behavioural model suggests that the AUD has now declined sufficiently for the valuation gap that we highlighted last year to be largely closed.
  
  

This is another indication that we are trading at more fair levels, ie for the AUD to decline more rapidly than fundamentals in 2014 (and bring about the needed reversion) it had to disconnect from them. However, as we have now ‘caught up’, the future direction of the AUD has become far more contingent on the evolution of fundamentals.

As such, the AUD’s sensitivity to fundamentals is currently heightened, and this is likely to remain the case for much of the year.

This means that further moves in the AUD cannot be driven by valuation concerns. It will need to be driven by either a shift in fundamentals or because a case can be mounted that the AUD should be trading at a discount to what the fair value is suggesting.

SO, WHAT IS GOING TO DRIVE THE AUD FROM HERE?

All of this is not to say that the AUD is anywhere close to providing a positive competitiveness shock, or that a bullish case for the AUD can be mounted.

In fact, competitiveness concerns are a key reason why we remain in an environment in which downside overshoots to behavioural models remains a distinct possibility.

To remain short the AUD in the current environment one needs to identify something more compelling than international competitiveness.

CHANGING RATE DYNAMICS WILL CHANGE PERCEPTIONS...

Our new economic forecasts highlight that we expect the RBA to act more dovishly than the market is pricing, ie to cut rates in both March and May 2015. Current pricing suggests that the RBA will begin its easing cycle in the middle of the year, and likely cut twice. As such, the ANZ view has not been fully discounted into the market.

Further, our rates strategists are now forecasting that the bond spreads between rates for Australia and the US will compress to zero by the middle of this year (Figure 4), and for a short period actually turn negative, and this is certainly not a part of current consensus expectations.

These two factors together should be sufficient to drive the AUD to fresh lows. And while in a modelling sense this will only shave a couple of cents from fair value, we believe that for the AUD, this time, the impact of the shift will be greater than the sum of its parts.

...AND THE AUD WILL BE LEFT WITH AN IMAGE PROBLEM

We believe that the decline in term rates in particular will create an environment in which we can get an overshoot in the AUD relative to fair value.

To say that differently, we think that the market will begin to demand a higher risk premium to remain a buyer of Australian assets.

Over the past four years the risk premium on AUD assets has remained small (ie AUD assets have been viewed as safer investments than they were in the past) and has inadequately reflected the fact that the risks inherent in holding these assets have been rising.

Given this, it is increasingly likely that within our forecasts horizon we see a more rapid pricing of this risk premium.

Looking back, there were two key factors that investors used to justify the contraction in the risk premium. First, the Australian economy was growing more strongly than that of the US, and that its growth trajectory was tied to China, the core engine of global growth. And second, that the level of public debt was low, and that the yield that was on offer relative to that of other AAA credits was very attractive.

There is some potential that this is set to change. The Australian economy is now clearly underperforming, while the Chinese economy remains in the midst of a large and challenging structural adjustment.

Further, it needs to remember that the past four years have been the exception, not the rule. Prior to the crisis in Europe, the relationship between a country’s public debt situation and the level of its currency was of no concern.

What mattered were the levels of aggregate (private + household) debt and the size of the external liability that the country held (ie how much of the financing of the liability was at risk). On both of these count Australia scores far less flatteringly than on a simple measure of government indebtedness.

If, as ANZ Research expects, these broader issues come into focus, while at the same time the spread available on Australian government bonds (relative to the US) falls to zero, then we expect that the risk premium will widen once again, and the AUD will overshoot fundamentals.

This sort of deterioration in perception has occurred before. Around the year 2000, global investors were also dismissive of Australia’s fundamentals.

With a mining-based economy in a new technology driven world, Australia was seen as uncompetitive and ill-equipped to compete in the modern global economy.

Through that time the AUD traded consistently cheaply relative to fundamentals, and we think the episode demonstrates the importance of perception, and provides a reasonable blueprint for 2015.

By the end of 2015 we expect that the AUD will be trading at USD 0.74, and that in 2016, the prospects for a rebound look equally unlikely.

CONSEQUENCES FOR OUR VIEW ON AUD/NZD

While we continue to think that the relative economic divergence between the Australian and New Zealand economies is very well priced with the cross at 1.04, an overshoot for Australia that is driven by an image problem and more intangible factors means that the fundamentals are likely to be overlooked. This should keep the AUD/NZD around current levels for the foreseeable future.

Daniel Been

Daniel.Been@anz.com