2013 was a tough year for the Australian dollar. It lost 15% to 20% of its value against most major currencies and the only currency it managed to outperform was the Japanese Yen. Slower growth, 50bp of easing and talk of currency intervention drove the AUD to its lowest level in 3 years versus the dollar and euro and it’s lowest in more than 4 years against the Chinese Yuan and British pound. In the long run, a weaker currency is good news for Australia but for a country with people who love to shop online for overseas goods, less purchasing power has made Australians feel poorer. Having a weaker currency however is critical to the recovery of export dependent economies and with growth expected to slow further in 2014, Reserve Bank of Australia’s Glenn Stevens says he wants to see the Australian dollar trading closer to 85 US cents or 4.5% below current levels. There a significant amount of macro factors that should drive AUD lower next year, but we do not see a material slide beyond 85 cents.
AUD Loses its High Beta Status
– Double Trouble: China and Commodity Prices
One of the main reasons why the Australian dollar performed as poorly as it did this year was because the currency lost its prized high beta status. Its correlation with global equities completely broke down with the currency falling while stocks around the world hit multi-year highs. Traditionally, the A$ rallies alongside equities because stronger global growth is positive for export dependent economies like Australia. However, in 2013, Australia failed to benefit from the global recovery because it has become too heavily dependent on China. The country benefitted significantly from the mining investment over the past decade and with investment slowing, the RBA has been forced to cut interest rates, offsetting any increase in non-Chinese demand. With growth in China expected to slow next year and commodity prices vulnerable to a rise in the dollar, it may be difficult for the Australia dollar to regain its high beta status in the first half of the year.
Correlation with Equities will Resume after RBA Drops Easing Bias
However in the second half, we expect the relationship between the Australian dollar and equities to resume when the RBA officially drops its bias to ease. Right now investors are worried that the RBA could cut interest rates again in 2014. The central bank cut its 2014 GDP forecast in November and made it clear this month that they are uncomfortable with the rise in the currency. Stevens talked about the possibility of intervention but one way to engineer a weaker currency is easing. Investors are divided on whether the RBA will ease again next year and until that uncertainty is lifted the A$ could remain weak. If Fed tapering fails to drive the currency lower and the economy continues to grow below trend due to rising unemployment and weak demand, the RBA could pull the trigger. Yet at most, the central bank only has 1 more rate cut left in them so even if they cut rates, their bias would shift to neutral limiting the slide in the AUD. This is consistent with the price action that we have seen in the AUD/USD on many occasions, which is a rally after a rate hike caused by a shift in bias. It is one of the main reasons why we expect a limited decline in the AUD/USD next year. The weaker currency will eventually provide enough support to the export sector to lift the economy and even if China slows, their demand for iron ore should be steady.
A$ First Half Pain, Second Half Recovery
In a nutshell we are looking for additional losses in the Australian dollar in the first half of the year followed by a recovery in the second half. The following chart shows the strong relationship between the Australian dollar and the differential between Australian and U.S. 10 year yields. In the near term, we don’t expect much movement in Australian rates but U.S. rates will be on the rise and this compression in the interest rate differential should drive the AUD/USD lower.
At the same time, the rally in the greenback will put pressure on gold prices and if the correlation that we have seen against gold holds in the coming year, it creates additional downside pressure on AUD/USD.
However from the perspective of positioning, speculators are holding a significant amount of short AUD/USD positions, which makes the currency pair vulnerable to a short squeeze as strong as the move in September. When speculators unwound their short positions in the third quarter, it triggered a more than 8% short squeeze in the AUD/USD. In order for a move of this magnitude to occur in 2014, we need a catalyst like the RBA officially dropping its dovish bias or the Federal Reserve taking a break from tapering.
AUD – Moderate Losses vs. USD, Bigger Losses vs. Crosses
– AUD/USD to 85 Cents
– GBP/AUD to 1.95/2.0
– AUD/NZD to 1.05
We are looking for further losses in the Australian dollar next year but its sell-off against the greenback should be gradual and limited to 85 cents. Bigger moves are expected against non-dollar currencies such as the British pound and New Zealand dollar. The recent break of 1.85 in GBP/AUD opens the door for a stronger rally to 1.95/2.0. AUD/NZD is also vulnerable to a move to 1.05 and we will discuss this in further detail in our New Zealand dollar outlook.