Shifting currency currents: the case for $US strength and $A weakness

BY David Bassanese | 26 September 2017
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The re-affirmed prospect of higher US interest rates – and renewed talk of tax cuts – suggests the year-long slide in the $US may be finally coming to an end.  While a firmer $US would in itself also tend to weaken the $A (at least against the greenback), weaker iron-ore prices and a steady RBA are further negatives for the $A.

The case for a bottom in the $US

As seen in the chart below, the $US has trended down for much of 2017 so far, after a strong rally in the second half of 2016.

Source: Bloomberg

The decline has reflected several factors. For starters, being bullish on the $US was a “crowded trade” earlier this year, with technical momentum indicators such as the weekly relative strength index (RSI) hitting around 70, which suggests “overbought” conditions. Disappointment that newly elected US President Donald Trump could not bring forth tax cuts quickly enough was another negative factor, as was a drop in US inflation – which led the market to reduce the risks of higher official interest rates from the Federal Reserve.

That said, the weekly RSI indicator for the $US has recently dropped to around 30 – suggesting the market is now technically “oversold”.  At the same time, in its just passed September policy meeting, the Fed affirmed its intent of raising interest rates in December, after having already lifted rates in March and June of this year.  What’s more, the Fed officially announced it will start gradual balance sheet reduction from next month. And contrary to market doubts, the median expectation among voting Fed members was that rates would still rise three times in 2018.

As seen in the chart below, there is still a wide gap between current Fed intentions (as reflected in the median year-end expectation for the Fed funds rates among Fed voting members) and interest rate futures pricing.  In short, the market feels the Fed will only hike rates once next year (rather than three) – and the gap in 2019 and 2010 is even wider!

Irrespective of whether US inflation lifts back toward 2% anytime soon, my sense is that the Fed is starting to feel it should still gradually “re-normalise” interest rates in any case, given the ongoing economic expansion and tightening labour market.   If so, market interest rates expectations will need to adjust eventually, which will help push up the $US.

At the same time, as Donald Trump settles into office, talk of a major tax plan continues to do the rounds.  Having failed to achieve much on health care, Republicans may feel under pressure to at least agree one significant piece of legislation ahead of the next round of Congressional elections.

The case for top in the $A

As regards the $A, there are two other non-$US negative factors at play. First, iron ore prices have started to weaken in recent weeks, reflecting ongoing growth in global supply and new Chinese plans to curb steel production due to pollution concerns.  China’s sovereign credit rating downgrades over recent months – due to rising corporate debt – also highlights the need for China to more seriously tackle lingering debt-fuelled industrial overcapacity, most likely once the 5-yearly leadership transition takes place next month.

As seen in the chart below, the iron-ore price peak in August at around $US80/tonne was lower than the previous peak in February at $US95, suggesting that the broader uptrend in prices from early 2016 is starting to unwind.

Source: Bloomberg

The second factor is local interest rates. While the Reserve Bank has talked up prospects for the Australian economy of late – and publicly agreed with the view that local interest rates have likely bottomed – it still suggests the eventual move higher in local interest rates is some way off.  Indeed, while some economists are now talking up prospects for higher local interest rates in 2018, my base case view is that weakening home building activity will result in economic growth falling short of the RBA’s 3% expectation next year, meaning official rates will remain on hold.

To my mind, the RBA would be much more comfortable raising rates were the $A closer to US70c than US80c – so while higher rates are a possibility next year, this only seems likely were the $A a lot lower than it is at present.

Investment Implications

A higher $US in general leads to a number of investment implications.  For starters, to the extent this implies weakness in the Euro and Japanese Yen exchange rate, it would be a positive for relative performance of European and Japanese equities – exposure to which is possible through the HEUR and HJPN ETFs respectively.

It’s also possible to gain direct investment exposure to an increasing US dollar (versus the $A) through USD and YANK.

 

 

 

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