Predictably, the announcement of the US tax reform lacked funding details and hence has come under immediate criticism. For instance, the Committee for a Responsible Federal Budget released a rough analysis saying the plan could cost USD3-7trn over the next decade, potentially “harming economic growth instead of boosting it.” Markets reversed early gains. We stay firmly within the reflation camp and view USDJPY setbacks to 111.00 as a buying opportunity. Today’s US durable goods release may confirm that US capex is on the rise, pushing rate and yield differentials wider in support of USDJPY. Today’s ECB press conference may see a cautious Draghi relative to expectations fearing an early tightening signal may push BTP spreads wider. EURUSD should stay offered below 1.0970 with the risk of closing Monday’s opening gap down to 1.0870.
Although Chinese equity markets recouped most of their early morning losses, the divergence in their performance relative to DM equity markets witnessed since November has caught our eye. We are bearish on low yielding commodity currencies and run aggressive AUD short positions. There are many reasons suggesting AUD weakness, reaching from too low AUD-supportive interest rate and yield differentials to fund Australia’s 60% of GDP foreign liability position, to an overvalued property market running the risk of unleashing deflationary pressures once prices come off the highs. However, our best reason for running AUD shorts is that Australia has builtup capacity to deliver into the ‘old’ China, an economy expanding via commodity intensive sectors such as investment and property. An evolutionary China rebalancing its economy away from investment and property will leave Australia’s commodity overcapacity exposed.
It may be debatable whether the equity performance gap between the US and China will widen further from here or whether China’s equity markets will catch up with the better US performance. What is true is that the recent decline in China’s stock prices came along with peaking margin debt. Higher RMB funding costs may have triggered leveraged share investors to take some chips out of the market, leading to the diverging China – US equity trend. The connectivity into the FX market comes via the RMB TWI weakness and may have contributed to the increase in RMB yields. While a lower RMB TWI helps China utilise its capacity and hence is good for its growth outlook, there is a risk within the highly leveraged economy that rising debt funding costs more than undermine the positive impact coming from the FX side. The relative weakness of China’s equity market may be a symptom of this development and this morning’s disappointing release of China’s March corporate profits did nothelp China’s equity markets either (the gain for industrial profits was 7.7% lower than in the January-February period, but it was 12.7% higher than the gain in March 2016). The message seems clear: China should concentrate on bringing its funding costs lower, shifting its focus away from RMB TWI weakness. Since the RMB is quasi-pegged to the USD, this shift of China’s policy focus will work in support of the USD.
AUD, with its significant trade exposure to China, should weaken most should China reduce its resistance to the USD rising allowing the RMB TWI to rebound. China may need capital inflows into the bond market to reduce capital funding costs. Since RMB hedging tools are not as developed as in G4 currencies and hence less efficient to use, currency stability is an essential tool convincing non-RMB-based investors to allocate funds into China. Consequently, the rising USD will put AUDUSD under selling pressure. This move may be leveraged by redirected capital flows from G4 into China, pushing G4 bond yields higher. Australia’s banking sector has reduced its wholesale funding dependence over the course of the past decade, but still has one of the most wholesale funding-dependent banking sectors within G10. Hence rising G4 rates and yields mechanically increase local AUD funding costs without the RBA increasing its rates. This is why we are sceptical of Australia maintaining its real estate strength at times of globally rising funding costs.