Australian dollar hits new highs with Chinese reflation hopes

DXY was firm last night as EUR and CNY sank:

But the Australian dollar was strong anyway and has printed a rough inverted head and shoulders bottom:

EM’s were even stronger:

Gold was stable:

Oil weak:

Metals firm:

And miners:

EM stocks too:

Junk was mixed:

Treasuries bid:

Bunds too:

And Aussie bonds:

Stocks hit new highs:

Not much data of substance after China’s deeply suspicious dump yesterday. But for now that’s enough for markets. The Aussie dollar is rising with Chinese-led reflation hopes. This is a subdued replay of what we saw in early 2016, the last time China hit the empty apartment building gas, only this time it is a lot more fake given the trade war is clearly punching a big hole in industrial production.

So how far does the AUD get? We’ve also got the easier Fed behind it, just as we did in early 2016. Indeed, that is the key consideration ahead, as Westpac describes:

AU data last week was supportive of lower yields with consumer confidence remaining weak and business confidence unwinding from its post-election spike, but with the RBA likely to give some room for their recent cuts as well as the Government’s tax package to filter through the economy (before delivering a November cut), the focus was on offshore price action.

The sell-off, driven by the CPI-led rise in US yields, was surprisingly large with the 10yr selling off 10bp and the curve steepening by 7bp. In our view, the moves is more a reflection of market positioning than a major shift in thinking regarding inflation expectations. That is, the “lower for longer” medium term view for rates, supported by RBA cuts and dovish global central banks and risks to global growth from trade and other uncertainties has been particularly prevalent and basically due a shakeout.

Forward RBA pricing is for another rate cut by late February next year, with some scope for a further cut beyond that. This week’s June employment report, in which Westpac expects to see a drop in the unemployment rate, is a clear risk event, however with around 120% priced in to the forward profile, it is unlikely to spark a dramatic shift in front end pricing.

None of that suggests that domestic valuations should shift too much in the near term. We expect the ongoing RBA cycle to keep rates low for longer. Hence we will either long or neutral in both a tactical and strategic sense over coming weeks.

Powell’s dovish testimony, delivered on Wednesday and Thursday last week, did little to disavow the market of their view that the Fed would cut rates at the 31 July meeting, instead extending pricing toward possibility of a 50bp cut. While Westpac remain of the view that the Fed will deliver only a 25bp cut at the July meeting, it is timely to examine whether or not the market – which is currently pricing 110% of a cut – has been an accurate indicator of Fed behaviour. Of the 96 meetings in our sample set, there has been 18 instances where the Fed either cut or hiked rates. On the day prior to all 18 of these meetings, the market was correctly priced for the outcome with >=80% priced in. There was only two meetings where the market was materially priced for a cut/hike that was not delivered – both of which were mid-cycle. The chart at bottom shows that it is not unusual for the market to price more than a 25bp move (hikes in the most recent 2018 examples), though looking back to the GFC period where Fed did deliver changes in excess of 25bp, the market had factored in a large portion of those moves, which is currently not the case.

After a brief period of flattening, the AU 10-30yr curve is steepening once again, driven by rising yields in the ultra-long end of the curve. As is often the case, the move reflects offshore price action, namely the leap higher in ultra-long UST yields that followed a weak 30yr treasury auction late last week. The auction, which had a higher than typical tail (the spread between the highest yield sold in the auction and the “when issued” level) followed a stronger than expected June inflation print last week. The chart at right shows that the relationship between AU and US curve shape has been strong since the beginning of the year, however with the market continuing the question the effectiveness of traditional monetary policy, and opening up the debate to what QE might look like in Australia, a move steeper on a stronger future growth and inflation profile could be described as premature. As to whether or not the steepening continues, the chart at left shows that among a selection of global counterparts, and while the trend in the US is clear the AU 10-30yr curve is steepest and that, coupled with carry and roll, could create a value opportunity in buying longer dated ACGBs, or encourage some buying flow.

I see two Fed cuts coming in H2 so while the market digests that there is scope for a stronger AUD. But I do not expect it to get far unless there is trade deal of substance (which I see as unlikely). So long as the trade war hangs over the AUD then it will struggle right along with the Chinese economy which is not about to take off. Bulk commodities will fall through H2 as supply issues ebb. And Europe is still worst, limiting EUR gains and USD losses, with Brexit hanging over it.

As well, the base case remains for only a weak rebound in the Australian economy and the focus will return to the RBA before long.