APAC FX Focus: AUD/USD can fall further despite supportive commodity prices

APAC FX Focus: AUD/USD can fall further despite supportive commodity prices

• Yield momentum has clearly shifted against AUD/USD as the market looks for fresh easing from the RBA at the November meeting.
• Higher commodities still underpin higher levels of AUD/USD fair value and will act as a medium-term support for the currency.
• This is unlikely to prevent lower A$ levels in the near term though – correlations with commodity prices have been declining in the past 12 months. Trade tensions with China may also be a source of concern in terms of how much benefit Australia actually enjoys from stronger China activity.
• The level of fair value is also declining due to lower yields, which typically coincides with weaker spot levels.
• The market is likely to maintain a short A$ bias into next month's RBA meeting. We retain a short AUD/IDR view via the 3-month forwards. Current spot is 10418 versus entry level of 10572 (see this link). See below for more details. Or see the shortened chart pack version here.

AUD falters as fresh RBA easing comes into focus

AUD/USD has fallen sharply this week, down over 2%. We are now below the 100-day MA (0.7097), which we haven't traded below in a meaningful way since May of this year. Helping these moves is a broadly stronger USD as European sentiment deteriorates on the Covid second wave. Closer to home, yesterday's speech by RBA Governor Lowe opened the door to fresh policy stimulus at the next RBA meeting in November. Market expectations around an expanded QE program, targeting longer dated yields have certainly risen. Yield momentum has clearly shifted against the AUD. The first chart below overlays AUD/USD against the 10yr yield differential between AU and the US. The AU-US 10yr differential has declined around 20bps over the past month, whilst spreads against the US in the 3- and 5-year tenor have slipped back into negative territory.

To the extent fresh RBA actions lower longer dated yields it can be expected to reduce or at least limit inflows into local debt securities, all else equal. The second chart below overlays the AU-US 10yr spread against inflows into local debt securities, on a rolling 4 quarter sum basis. If we replace the 10-year spread with a different tenor, such as 5yr or 3yr, a similar picture emerges.

Of course, in a world with negative interest rates on large chunks of sovereign debt, Australia bonds are still likely to hold some appeal, particularly given relatively low levels of government debt. Nevertheless, a repeat of what we saw post the 2008 global recession, where debt inflows recovered very strongly, seems unlikely.

Chart 1: AUD/USD and AU-US 10yr spread trend lower 

Chart 2: AU-US 10yr spread and inflows into local debt securities

Stronger commodities are an important offset

Whilst yield momentum is suggesting further downside for the AUD, with 0.7000c likely to be next target, strength in commodities is painting a more resilient/upbeat picture. The combination of commodity prices and yield differentials does a reasonable job capturing AUD trends. The third chart below presents the fair value of AUD/USD, which reflects a regression of two factors: commodity prices and the AU-US 10yr yield differential, versus spot AUD/USD. The model fit is quite high at around 80%. Note we use the RBA commodity price series in USD terms. Current fair value is pegged at around 0.7600c, which is well above current spot levels and indicates that stronger commodity prices are more than offsetting weaker yield momentum.

Chart 3: Simple fair value for AUD/USD suggests the A$ is cheap

Insofar as China is a key driver of Australian commodity demand, the outlook is a reasonably positive one at the current juncture. China data momentum remains strong, underscored by this week's firm trade report and the upside surprise on new lending and aggregate financing data. The fourth chart below overlays aggregate funding against Australian commodity prices. Where commodity prices go drives Australia's terms of trade, which at the end of Q2 this year, were still close to 15% above the average level of the last 20 years. This can still act as a source of support for the A$ over the medium term.

Chart 4: A stronger China typically leads to higher AU commodity prices 

But is unlikely to prevent further weakness in the near term

It's unlikely though that firmer commodities can prevent further A$ weakness in the near term. Firstly, the rolling 3yr correlations suggest commodities are not as an important driver of the A$ now compared to a few years ago, see the fifth chart below. It's also noteworthy that the China uplift is not boosting imports from Australia, at least not at this stage of the upswing. Chart 6 overlays China aggregate funding momentum, with import growth from Australia. Trade tensions between Australia and China have risen a notch, there were reports earlier in the week around China banning Australian coal imports, while today there were reports that Australian cotton exports to China could be affected (see this link). Tensions can ease as quickly as they risen but the market may remain cautious in the near term around extrapolating a stronger China activity into higher AUD levels.

Chart 5: Commodity price correlation with the A$ has fallen in the past 12 months

Chart 6: China uplift not boosting imports from Australia yet

The final points we would note are around fair value. Even if commodity prices hold at current levels, fair value can still drop via lower yield differentials. The shift in yield differentials to date this month has knocked off half an AUD cent from fair value. If the yield differential drops another 10bps this month it will translate into slightly larger than 1c off fair value. If the level of fair value is coming down it typically coincides with weaker AUD levels, even if the actual level of fair value is above the prevailing level of spot. The second factor is that the gap between fair value and spot for AUD is still modest by historical standards. Hence, we can see greater divergence before 'value' is seen in being long the AUD.