First, the flow picture is a greater drag on the Aussie than the kiwi. Net bond inflows to Australia have turned negative sooner and at wider yield spreads to USTs than we predicted in the May Blueprint. So far this year net outflows have run at 3% of GDP, and foreign ownership of sovereign bonds has dropped below 60% for the first time since 2009. Yet with the post-mining economy dependent on deficit spending, supply will remain high and Australia relies on foreigners to absorb at least half of it. Even at the current yield spread it will need a cheaper Aussie to lure foreign bond investors back. And the pressure is likely to increase. Long-dated yield spreads closely track front-end rates pricing and we see risks skewed toward further compression as the market under-prices a Fed hike in December.
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New Zealand by contrast is still seeing net bond inflows. Moreover, while Australia’s current account has slipped below cyclically adjusted long-term averages, New Zealand’s improving trade balance underpins a positive current account trend. The kiwi is now 5% cheap on our CA-driven FEER models, whereas AUD is 5% rich. Terms-of-trade trends are likely to exacerbate the divergence. Bulk commodities are trading rich to our top-down macro models as well as to our commodity strategists’ bottom-up frameworks. Milk prices by contrast have bottomed out.
Overall, New Zealand’s negative but stable basic balance contrasts favourably with Australia’s, which is set to extend its deterioration into deficit in the absence of meaningful depreciation. Moreover, both current accounts will likely come under pressure as housing booms reduce saving ratios. In New Zealand, however, this dynamic has less FX impact because house price inflation is less home-made than in Australia but driven by offsetting property inflows.
For vulnerable valuations, take a look at AUD/JPY instead, which is still trading 25% above PPP. Since the launch of QQE, real rates and the terms of trade no longer explain this persistent overshoot. The missing variable is Japan’s monetary base growth.
Notwithstanding the cost of carry, we thus like selling AUD/JPY not only on weak Australian fundamentals but also our view that the BoJ will likely have to taper faster than the market appreciates.