USD Strength, China and Yuan Weakness, AUDUSD

Despite being with the consensus we underline our bullish USD view, but unlike November/December when the USD rise was mainly driven via low yielding currencies seeing USDJPY gaining 15% within seven weeks, we put our bearish focus towards Asia and Australia. The dominance of USD strength prevented the AUD from benefiting from rising commodity prices and the associated terms of trade improvement. Going into December, the AUD started to underperform other currencies, which we have partly exploited running AUD shorts against the CAD and the NZD.

First, improving terms of trade may not necessarily lead to better investment spending should Australian companies regard higher commodity prices as only a temporary development. Indeed, mining investment plans have not picked up as much as terms of trade have. During the 2009/2012commodity boom, Australia’s mining sector had built up overcapacities putting the return of equity during the following commodity slump under additional downward pressure. Nowadays, mining companies seem to be more careful, improving corporate cash positions instead of engaging in new investment activities. Hence, better commodity prices fail to develop growth supportive second round effects.

Secondly, there are two major risks for the global growth outlook and both of these risks will not bode well for Australia. Global trade growth has stalled since 2013, which may be linked to trade growth reaching its natural limitations as global imports and exports reach 60% of global GDP. This observation is already a negative for overcapacity-running and manufacturing oriented economies, of which most are located in Asia. Should the incoming US administration provide new trade hurdles it will hit trade surplus countries most. Note, China’s State Information Centre suggested a one-off devaluation of the yuan exchange rate should be considered to maintain the currency’s stability at a balanced level. These comments from the State information Centre may have to be seen within the context of the current trade discussion in the US.

The other risk is related to the underlying strength of the Chinese economy. Unlike January 2016 when most of the markets’ risk-focus was on China, investors are looking in other directions when trying to locate potentially upcoming market risk events. This morning’s release of a strong Caixin report (51.9 in December from November’s 50.9) showing growth momentum in China’s manufacturing sector in December posted the strongest monthly upturn since January 2013and seems to justify the view of China growth risks as not significant. Indeed, over the past year the Chinese economy performed better compared to downbeat expectations, supported by loose fiscal and monetary policies.

China’s monetary policy may from now on act less as a growth support. Instead, currency outflow pressures and ambitious house price valuations suggests a tighter PBOC policy approach, thus leaving, within an environment of lacklustre private sector investment activities, fiscal policy as the only game in town supporting the Chinese economy. Meanwhile, markets will carefully examine if the State Administration’s measures, effective from 1st January 2017,have the desired impact to reduce RMB outflow pressures. These measures include citizens not using the USD50k per person quota for purchases of property, securities, life insurance or investment-type insurance.

Last year, the AUD often appeared on top of many selling recommendation lists. Not so this year, where we feel markets may not recognize the entire AUD downside potential. For starters, AUD-USD sovereign yield differential is at historic lows. Hence, the AUD qualifies less as a ‘yielding currency’, bearing in mind that Australia’s net foreign liability position has further deteriorated. Its banking sector has reduced its whole sale funding exposures since the financial crisis, but within an international comparison its banks still feel the impact of rising USD funding costs more than most other G10 banking sectors. An interesting read is provided by the most recent BIS release examining the international impact of changing funding costs of the USD, EUR and the JPY. Countries with high foreign funding needs should be most exposed within an environment of rising international funding costs. Add to this mix global trade and Chinese growth risks and the outcome should be a much lower AUD.