Commodity FX: are we reaching a turning point?

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Commodity FX: are we reaching a turning point?

Vasileios Gkionakis, PhD - Global Head of FX Strategy

Vasileios Gkionakis, PhD

Global Head of FX Strategy
  • Commodity currencies have been hammered this year with AUD and NZD down 9% year-to-date (YTD) on concerns about global trade, world growth and higher US real yields
  • Too much negativity seems to be priced-in. Based on our central scenario of a slowdown with no major global downturn and lower US real yields as inflation picks up, the hefty misalignments in some commodity FX with underlying fundamentals offer attractive opportunities
  • CAD tops our core commodity currencies, supported by a new NAFTA deal, high oil prices, a strong economy and tighter monetary policy
  • AUD stands a more than fair chance of rebounding in 2019: as long as China engineers a soft landing then external headwinds should abate. Domestic dynamics are favourable and we think there is an increasing risk that monetary policy will tighten more than the market expects
  • NZD, on the other hand, will remain the weakest link. Growth and inflation disappointments have alarmed the Reserve Bank of New Zealand (RBNZ), suggesting that policy rates will remain on hold for longer. We look for upside in AUDNZD, in line with the widening growth differential between the two economies.


Commodity currencies: licking their wounds

The core commodity FX bloc (AUD, NZD and CAD) has lived through a pretty rough year: the CAD was penalised by the drama surrounding the NAFTA renegotiations, falling 3.5% against the USD on a YTD basis, although this was cushioned by higher oil prices and the Bank of Canada’s (BoC) tighter monetary policy. At the same time, AUD and NZD each fell 9% during the same period on trade dispute concerns, Chinese growth slowdown, higher US yields and (in NZD’s case) a dovish shift in the central bank’s stance.

Going forward we expect some stabilisation in the near term, followed by (varying degrees of) gains. Our top pick is the CAD where we expect sustained appreciation towards 1.23 against the USD (by end-2019) i.e. about 4% higher than current forwards, with risks skewed towards more downside. AUDUSD should be relatively trendless over the next few months but be able to make headway in 2019 and approach 0.75 by the end of next year, very close to our long-term fair value estimate of 0.77. The NZD, however, is likely to remain the weakest link, staying flat on a 12-month horizon. In what follows, we set out our reasoning.


The USD factor

As we discussed in our latest FX monthly “US fiscal policy: the dollar’s Achilles’ heel”, we articulated a bearish medium term view on the dollar, largely based on irresponsible fiscal policies (fiscal expansion when the output gap has closed) that will trigger higher inflation and higher US risk premia. Our working assumptions here are: 1. Global growth slows but does not degenerate into a major downturn. 2. US growth slows somewhat, inflation picks up and hence, US real yields start to be compressed. 3. Although not painless, an eventual US-China trade compromise will avert a full-blown trade war. 4. Chinese growth cools off somewhat without a hard landing thanks to an appropriate fiscal and monetary policy response, and 5. Italian political developments ease and do not create wider market risk aversion. As long as the future is roughly in line with our central scenario, USD depreciation should trigger a broad-based appreciation across undervalued G10 currencies where central banks have started (or are about) to engage in monetary policy tightening. The magnitude of gains will of course depend on idiosyncratic stories. More specifically:
 

As long as the future is roughly in line with our central scenario, USD depreciation should trigger a broad-based appreciation across undervalued G10 currencies where central banks have started (or are about) to engage in monetary policy tightening.


CAD: dislocated from yield differentials and oil prices

Canadian real GDP growth has accelerated in 2018, rising from 1.7% quarter-on-quarter (QOQ) annualised to 2.9% in 2Q 2018. Moreover, the positive resolution to the NAFTA negotiations (now to be renamed US-Mexico-Canada Agreement is likely to alleviate recent business concerns. In parallel, inflation is trending up, with headline around 3% and core just over 2% year-on-year (YOY). This favourable dynamic has closed the output gap, prompting the BoC to hike interest rates by 100 basis points (bps) since mid-2017 (from 0.5% to 1.5%). The market (correctly, in our view) is pricing-in further tightening of around 90bps over the next twelve months. Importantly, oil prices have rocketed this year, as WTI moved from $60 per barrel to $75pb on still-healthy demand and supply constraints.

Despite this favourable backdrop, the CAD has not benefited this year (USDCAD up by 3.5%) partly due to the strong dollar and partly to market anxiety about a potential collapse in the NAFTA negotiations that would damage Canada’s trade with the US. However, USD momentum is losing steam (with most USD gains concentrated in 2Q 2018 with the TW USD since dragging its feet) and the agreement on the USMCA is diminishing trade-related angst. In our view, this sets the stage for multi-quarter CAD outperformance.

Our short-term model (which uses real time data on real yield differentials and oil prices) suggests that USDCAD should be trading closer to 1.19, which is a sizeable near-10% misalignment. Our long-term fair valuation models indicate an equilibrium value of 1.24. So CAD finds itself undervalued (in a variety of modelling frameworks), and enjoying the tailwinds of high oil prices and prospects of tighter monetary policy. This looks, to us, like a particularly favourable backdrop for the currency.

We forecast USDCAD at 1.27 by the end of this year and at 1.23 by the end of 2019. We see risks skewed for more downside because typically when convergence to fair value gains traction, more often than not prices move beyond equilibrium levels.


AUD: battered and bruised but not broken

AUDUSD has depreciated 9% this year, making it one of the worst performing major FX pairs. The dollar has certainly played a role but the currency’s exposure to global trade and the Chinese cycle are probably responsible for most of the weakness (the trade-weighted AUD is down 6.5% YTD).

We anticipate that in the run-up to the year-end, little will change and AUDUSD should continue to trade close to 0.70 as the threat of trade war escalation looms. However, assuming no systemic tremors, the currency may turn a corner as we head into 2019.

First, the Chinese growth cycle is likely to result in a soft landing. Over the last decade, similar AUDUSD depreciation rates have come hand-in-hand with pronounced Chinese growth rate declines, typically higher than the ones we foresee (we forecast China annual GDP growth will decelerate from 6.4% in 2018 to 6.3% in 2019). In that respect, all this seems to be already priced-in, and as long as Chinese authorities are successful in achieving a controlled slowdown, (due to fiscal and monetary policy responses) it seems likely that AUD is now close to its bottom.

Second, there is a material risk that the market is underestimating the extent of monetary policy tightening over the next one to two years. The rates market suggests that investors see only 11 bps of hikes over the next year and a total of 38bps over two years. However, Australian GDP growth is now running at 3.4% YOY – the highest since 2012 – while the labour market continues to add jobs at a brisk pace and the unemployment rate hit a six-year low of 5.3%. With vacancy rates rising (amid some shortages of skilled workers), the labour market is becoming increasingly tight. Although wage growth remains low by historical standards, there is evidence of a recent pick up, which is quite likely to continue on the back of these dynamics. Headline inflation is now at 2.1% (Reserve Bank of Australia target range of 2%-3%) exhibiting upward momentum.

Finally, the AUDUSD appears cheap (by nearly 8%) in our valuation metrics: our short-term model (real yield differentials and raw industrial prices) suggests AUDUSD should be trading at 0.77, virtually identical to the fair value estimated by our long-term equilibrium models.

We forecast AUDUSD at 0.71 by the end of this year and at 0.75 by the end of 2019, or just over 4.5% higher than forward rates.


NZD: the weakest link

Beyond the dollar’s unfavourable dynamics earlier this year and negativity over global trade, NZD has been penalised by lower dairy prices (-7% since June) and the dovish shift by the RBNZ. In August, the central bank downgraded its 2019 GDP growth forecast to 2.6% yoy from 3.1% yoy previously. It also signalled that it saw the cash rate steady at 1.75% until late 2020, longer than previous projections.

This change of stance follows the economy hitting a soft patch this year. GDP growth decelerated to below 3.0% YOY while inflation failed to stay above 2.0% and now hovers around
1.5% YOY. These developments, alongside global trade jitters, appear to have injected some caution into RBNZ’s assessment, which wants to ensure that pricing of monetary policies domestically does not follow the same tightening path seen in most other developed economies.

With some tentative signs that the unemployment rate may be bottoming and less supportive momentum on growth and business confidence fronts, we believe that this situation is unlikely to change materially over the next quarters. Although a rate cut seems unlikely for now, rate hike expectations should remain contained, providing little (if any) support to the NZD.

We forecast NZDUSD at 0.64 by the end of 2018 and at 0.65 by the end of 2019.


Risks

There are two main risks to our forecasts: first, a more pronounced global downturn relative to the slowdown we are currently projecting (e.g. triggered by a hard landing in the Chinese economy). Our analysis of the global business cycle’s phases suggests that periods of slowdown are not associated with weakness in AUD, NZD or CAD. However, periods of outright contraction generate currency depreciation and so high-beta, globally exposed FX would be very vulnerable to a significant deterioration in global growth.

Secondly, if US inflation picks up even more abruptly than we expect, there is a risk that the Fed adopts a very aggressive tightening bias, raising interest rates well above the 3.25% level we expect. In this scenario, there would be a period of significant nominal yield spread widening between the US and the rest of the world. This would potentially underpin the dollar for a number of months. Significantly tighter financial conditions would also weigh on commodity prices, putting AUD, NZD and CAD under even more pressure.
 

Significantly tighter financial conditions would also weigh on commodity prices, putting AUD, NZD and CAD under even more pressure.


Managing commodity FX exposure under our base scenario

We favour upside in the CAD, which is our top pick amongst the core commodity FX bloc. We think AUD is bottoming out and there is more than a fair chance that it will rebound in 2019. For investors concerned about exposure to USD-beta, we believe it makes sense to position for AUDNZD upside, in line with the growth rate differential between the two economies.

Wichtige Hinweise.

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