AUD GDP Miss, CAD Divergence and OPEC, JPY correction, Interest Rate Drivers of FX
The focus is all on AUD today which weakened,at its most 0.7% overnight,as 3Q GDP contracted by more than the market was expecting (- 0.5%Q, market -0.1%Q). The story is clear – the prior quarter saw an upside surprise as public spending picked up by 4.8%. This couldn’t be repeated again at that pace of spending as the government is worried about losing its AAA credit rating. The result was 3Q public spending contracting by 2.4%Q,nothelping the overall GDP print. Usually the idea of government consumption is to boost business investment too, but as the mining industry is still dealing with a terms of trade shock and restaurants and retail consumption isn’t sufficient to compensate, the ‘fiscal boost’ of 2Q was short-lived. Even after today’s downside surprise, the market is still not setup for the RBA to cut rates next year, which we are forecasting. We believe that AUD remains a sell from current levels, especially on the crosses, with AUD/NZD helped by yesterday’s strong dairy auction.

2014 saw massive monetary policy divergence within the G4 space,allowing USD to rally over 15%. Now we look at the policy divergence in the commodity currency space and see renewed opportunities that are not yet priced in. From the USD side, the market is already expecting 1.7 x 25bp of hikes in 2017,and it is for this reason that we expect a short-term USD pause.From the AUD side,however, the markethas only priced 7bp of cuts by the middle of the year, while our economists expect 25bp. It may now take the RBA to shift its tone from yesterday’s note on downside surprises to growth to explicitly saying that it is worried and could act to make the rates markets reprice cut expectations. The RBA minutes, released on December 20, will now be in focus together with 3Q house price data on December 13. Of course, today’s strong iron ore trading during Asian hours again supports the terms of trade but we don’t think it is sufficient to keep AUD supported. The Canadian rates market is more fairly priced for BoC expectations, we believe. Today’s BoC meeting should help our short AUD/CAD position to break through the August lows.

USD/CAD has started to diverge from the 2y rate differential, but it should still be the monetary policy outlook driving the currency today. In general, our constructive outlook on CAD is based on the idea that the BoC is to keep rates on hold for now and the US economic growth expected in 2017 should spill over to Canada too. Yesterday’s Canadian trade balance was strong on the headline number -1.13b (-1.7b exp.) but was mainly driven by a contraction in imports. Non-commodity export volumes fell by 1.5% and, while this is not great for an economy that is trying to deal with a terms of trade shock and like Norway is also seeing a bit of a fiscal support, the data aren’t sufficiently bad to make the BoC take action to cut rates. This is why we see CAD outperforming on the crosses, with potential for EUR/CAD to cross below its December 2015 low around 1.40. Today we think the BoC could note that there are downside risks to growth, but we think that this isn’t sufficient to make it want to look to cut rates next year. Oil prices need to be on their way back to the US$30s for that to occur. Oil prices remaining fairly well supported after the OPEC deal should also help CAD on the margin. This environment of a tactical pause in USD could see MXN recover too, towards the 20 level. Mexico’s deep water oil auctions went well, with eight out of ten blocks awarded, while very strong bids for bonds issued by state oil company Pemex highlight strong demand for Mexico paper.
We outlined yesterday that we expect a short-term pause in USD’s appreciation, meaning even USDJPY could see a setback towards the 112level. However, we are not participating in the setback and would only use it to add to short JPY positions. This morning the BoJ’s Iwata reiterated the bank’s stance to buy as many JGBs as required to keep the 10y close to 0%, in particular he thinks the bank will need a large scale of JGB purchases to control rates. The expansion of the BoJ’s balance sheet and the interest rate differential with the world should continue to weaken JPY over the medium term. What is now becoming a driver of the story is the development of local risk appetite. Favourable tax policies and an outperforming local equity market should push more investment into riskier assets. Those riskier assets may be outside the country, which would weaken JPY if done on an FX-unhedged basis.