Even before Friday’s break of the parity level on AUDUSD, significant changes were underway on the Aussie which had lead it to be the weakest performer on the majors over the past month. Many have claimed that the Aussie has been fundamentally over-valued for years, but more than any other, it’s the FX markets where the old saying “markets can stay irrational longer than you can stay solvent” applies. So what’s changed now?
Firstly, the Aussie is no longer trading so strongly as a commodity currency. The Aussie used to move very closely with the fortunes of global commodity prices, together with the domestic mining sector. This is no longer the case. Indeed, so far this month we’ve seen a divergence, with factors that would have traditionally been supportive for the Aussie being met with a declining currency (against all majors apart for the yen). The breakdown in correlation is not new. Indeed, we can go back to the middle of last year to see the initial breakdown in some of the commodity currency correlations (see “The shifting sands of FX”). What is of notable is the severity of the move.
This brings us on to the second observation. For the past 6 months, markets have been moving away from (global) liquidity driven risk trades, focusing more on domestic developments. This can be seen in the greater sensitivity of currencies to data surprises (see “Proving the new FX regime”). This was also true for the Aussie in the first three months of the year, which accounted for much of the move down to the 1.02 area in early March and the subsequent recovery to the 1.06 area. But more recently we’ve seen this correlation break down, in part as a result of the latest rate cut from the RBA.
The above two observations combine with what we’ve seen from China of recently, both in the data and also beyond. China’s long-held ambition to move towards a more service sector orientated economy is slowly but surely starting to bear fruit. Early data for this year suggests that service sector output overtook that of the industrial sector for the first time. At the same time, growth itself is slowing, with a natural consequence being that Australia’s main export destination sectors are slowing faster than the economy as a whole.
The final point to note is that the premium the Aussie used to command from a sovereign risk perspective (good fiscal numbers compared to most peers) has also narrowed this year. Both the Aussie budget numbers have fallen short of expectations at the same time that the perceived riskiness of the Eurozone periphery has declined. Our series which tracks the weighted average of Eurozone peripheral bond spreads (over Germany) is just above the lows for the year, having halved over the past 9 months. Now this may be just a transitory move for the eurozone, masking the still perilous fiscal issues underneath, but for now the perception is holding. This could mean that investors who had viewed the Aussie as something of a safe haven from the sovereign storms elsewhere at a minimum don’t add to their positions, or they adjust Aussie allocations lower as a result.
Does this mean the Aussie is heading for the sort of re-adjustment seen by the yen over the past 6 months? Most likely not, given that it still retains a decent advantage on both rates and global growth differentials. But the moves over the past month are part of a wider re-alignment that has been underway for nearly a year now in terms of what is driving the currency. For this reason, when combined with the better dollar tone, we have now likely entered into a new sub-parity trading range.