The recent rally in the AUD has coincided with a rally in commodities, most notably in the oil and iron ore markets. However, we think that the move in the AUD is more likely reflective of a shift in broader themes, rather than a currency reaction to stronger commodity prices. If the recent rally was just about pricing in a new commodity price paradigm, then the rally in the AUD would have been far more limited. Weightings in the RBA non-rural commodity price index mean that the recent move in iron ore prices – a rally from USD38 to USD60 – shifts the index from 51 to around 56. Our long-term model of the nominal AUD estimates the impact of this scale of move in the commodity price index; it is worth around one cent on the AUD. To date, since the rally in commodities began, the AUD has moved a bit more than six cents higher. Thus, if it was commodity prices alone that had driven the AUD, then the AUD has already moved too far.
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SUSTAINABILITY OF AUD STRENGTH? We continue to think that this near-term strength will provide significant opportunities to reset hedges for a sharp decline in the AUD. In particular, we see a number of factors that make this AUD rally self-limiting:
First, growing evidence of a broadening in growth, wage, and inflation pressures in the US will ultimately push the Fed to do more than the market currently expects. A sustained rally in oil, or indeed even a stabilisation at current levels over the northern summer, will start to shift the balance of risks for the Fed, and this would be further exacerbated by a period of lower volatility in financial markets (though the Brexit vote in June may create issues). Should Fed rhetoric or forecasts become more hawkish in response to the better market vibes, then a sharp rise in longer term US yields would push the USD to reassert its strength.
Second, the rally in commodities (iron ore in particular) will be capped by the supply dynamics in the individual markets. Iron ore remains with about 50% excess capacity relative to long-term steel demand expectations.
Third, the tightening in financial conditions (as the AUD rallies and as banks continue to pass on regulatory tightening) in Australia will limit the RBA’s willingness to acknowledge the better global circumstances, and could in fact drive the RBA to ease once again. • Finally, the debt load that already exists in China will mean that any recovery we do see will prove temporary as officials start to tighten up again once recessionary risks have passed. In addition, while current levels for the AUD.
In a trading sense, we still struggle to hold outright long AUD/USD positions given the dislocation from other risk assets. As such, we think that AUD/NZD looks like the best cross to use to benefit from nearterm AUD strength. The cross usually favours the AUD in neutral and positive risk environments, and the RBNZ is actively easing rates while the RBA remains on the sidelines.
