The Reality Check:

It seems sell side expectations of a still hawkish RBA will come down further in coming months. The general perception is that Australia’s investment led resource/mining boom will keep tighter labor market and that along with the rising income levels will result in above trend GDP growth, continued inflationary pressures and a hawkish RBA.

The reality seems to be a bit different. When evaluating Forex, the Australian monetary conditions are pretty tight—real effective cash rate is above the pre-crisis level, credit conditions are tight as spreads are widening, banks are not willing to lend, the mortgage credit conditions are at 35 year low, the wage growth is not triggering spending due to record savings rate and a depressed housing environment. The consumer confidence is not improving as well. RBA, too has noted households being worried about their own finances and cautious in spending and borrowing patterns.

This begs the question why a still Hawkish RBA? The logic used by many sell side guys and interestingly by RBA too is the one mention above— historical high terms of trade (outcome of higher commodity prices)  resulting in investment boom causing income & wage growth, higher spending and inflation.

RBA’s preferred inflation measures are still within the target band and RBA in most recent policy statement did mention 12 months inflation to stay within target vs last statement mentioning bottoming in inflation; employment picture is not that great, though unemployment rate is improving but this is an effect of rise in part time employment with continued declining trend in long term employment additions. Also wage growth in the so talked about mining sector is only 4% yoy and remember the beloved mining sector is less than 2% of overall employment. This should keep RBA away from hiking.

Also how can we forget that this boom (don’t forget that mining investment will be 5% of GDP only) is a reaction of the surge in commodity prices and terms of trade; if commodity prices don’t match yoy growth this will be a drag on this boom. Mining is a capital intensive industry which is sensitive to interest rate hikes.

Trades:

What makes all this situation very interesting is an almost flat yield curve… Historically, this foreshadows slow GDP environment.

AUD is a carry currency with highest real rates in G-10 and one can expect that when RBA becomes dovish AUD will sell off as the carry advantage fades away and long rates comes off. But with yield curve this flat chances of long rates selling off are probably low.

The fate of AUD will be a function of following scenarios:

• ·Global Slowdown: What matters most for AUD is the Asian growth story as it’s nearly 70% of Aussie exports:

o    Asian Soft Landing: If tighter monetary conditions in Asia (every central bank is on tightening mode in Asia ex-Japan with Vietnam hiking by 750 bps, china 100 bps and India 250 bps and on average Asian central banks expected to hike another 50 bps by the rest of year) causes slowdown in Asian imports this will serve as a dent on AUD growth story which is an external growth story. But this further will be finally determined by these two scenarios:

§Sell- off in Global Commodity prices: Now imagine this—Australia adding to capacity of its major export contributors by 20-25% (these are significant chunk of global exports, for instance iron ore Australia is 40% of global exports) and capacity additions lead to surge in global supply with commodity prices coming off? This will be a two wedged sword for AUD—exports will fall both in volume and value, terms of trade will get less favorable meaning the investment boom gets delayed. If we exclude every other factor the single most determinant for AUD will be terms of trade and any sharp selloff in commodity prices means short AUD not only in short term but if this can be cyclical move down in AUD as the greatest tailwind for AUD and the Aussie economy overall won’t be there any long. That is why AUD will be treated as highest beat currency prone to risk appetite and becomes more important with a dovish RBA.

§Commodity prices sells off slowly but remain elevated: Many will view any selloff in commodity prices as a –ve AUD scenario but this can unfold as a move down in aud but the cyclical strength remains there. This scenario where commodity prices don’t fall sharply looks likes a most probable outcome and if I incorporate RBA in it this it still is a short AUD scenario as halt in cpi growth over target will eventually force sell side to accept a dovish/non-hawkish RBA and as OIS indices still expecting a 20/25 bps hike by next year, will put pressure on AUD.

• ·Asian growth continues: Terms of trade become more favorable, surge in global commodity prices sets ground for hawkish RBA and now that can cause long rates to go even higher. Faith in investment mania gets stronger. This will, in one aspect be very bullish AUD but key determinant will be how global yields react. Remember RBA was very pre-emptive and doesn’t have long way to go in terms of tightening whereas developed economies still have that room and this can result in Aussie  vs developed world rate spreads compress and be –ve for AUD.

One thing to keep in mind is that despite the talks of Australian export boom they are and have been running a current account deficit for at least 3 decades and will need higher flows i.e higher real rates to attract portfolio investments so AUD’s status as carry currency is probably not at stake. Also in case fiscal pressures build and we see safer haven trades Australian AAA rated bonds will see inflows especially after commonwealth budget announcing a return to fiscal surplus.

Bullish Scenario: wage growth leads to higher retail sales (retail sales are highly co-related to house pricing and house prices correlated to terms of trade), it’s possible if savings rate has peaked.

For forex the financial markets, globally, have become a single vector market. The co-relations between forex, commodities and global equities, though have come off a bit, still makes the forex markets the key determining factor for all other asset classes.

It’s high time that we replace the heavily used investment term “double edged sword” with a triple sided forex blade. Well any nuanced investor will guess the 3 sides pretty easily—the end of QE2, sovereign crisis of peripheral Europe, Middle East tensions causing a surge in commodity prices. Thanks to the rebound in Japanese Industrial production, otherwise one would have to create a 4^th separate nuclear side of the blade which would most probably be known as the side of tsunamis and earthquakes.

The world of forex, these days, can be pretty simply divided in following categories:

1)    High growth economies of Asia ex Japan & other EM

2)    The slow growing developed world

3)    The commodity currencies

4)    The high yielders

5)    Defensive currencies, also known as funding currencies

They can also be grouped with respect to inflationary pressures in the domestic economies and the phase of central bank policy cycle. Asian and other growing economies in the emerging world are generally the ones facing inflationary pressures. The inflation in these economies is both a domestic dynamic (result of loose fiscal and monetary policies adopted by these countries in the midst of financial crisis) and exogenous factors such as high commodity prices, EM countries being net importers of commodity and raw materials.

This inflation shock is the prime driver of tightening monetary stance in this bloc. The big fx moves here will be driven by market expectations re how many more hikes to go. Not to forget that the Asian central banks have very tight monetary policy stance and are expected, on average, to raise interest rate by 50 bps before policy normalization happens. In this regard we will see individual currencies trading higher on the back of interest rate hikes. Central bank meetings and their comments on inflation and wage pressures will be key fx movers, as always.

On the other hand we have two major central banks in the world far away from a tightening cycle. Bank of Japan and Federal Reserve both maintaining near zero interest rates and maintaining “extended period language” have created a massive carry trade opportunity.

Economies like Brazil and Australia offer much higher interest rates 11.75% and 4.75% respectively, hence the carry trade opportunity. The rationale is simple: borrow from low yielding central bank at 0-0.25% and invest in high yielding currency which is even expected to tighten/raise rates even more.

One knows that FOMC is on hold at least for next 12 months and BOJ is in no different situation, though the forces causing loose monetary policies vary. One thing to remember about these carry trade is its ability to severely underperform in times of increased risk aversion. When carry trades are unwound currencies like JPY and USD benefit. Hence both are the funding currencies which tend to outperform in times of stress along with Swiss francs (CHF). These three together are known as reserve currencies.

The commodity currencies, mainly AUD, NZD, CAD, NOK are extremely co-related to global growth scenarios. They are all high inflation zones with respective central banks tightening and exports very much tied to commodities. As commodity prices surge, investors tend to prefer this group.

While investing in fx these days, one thing to watch are the CDS spreads to gauge the risk premium for sovereign debt issues related to certain European economies. More famously knows as PIIGS crisis, will decide the fate of EUR in 2011.

Below you can see the summary views for major currencies:

FOREX MARKET TIPS

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