FX Daily – Two percent? Tell him he’s dreamin’
26 July 2016 (1 page/ 208 kb)
Ahead of this week’s inflation data, there are three main reasons to stay short AUD, whether against an equally weighted G3 basket or just against EUR, as we recommended last week.
First, an August rate cut still looks underpriced at 60%. Our economists expect core inflation for Q2 at 0.4% q/q and 1.5% y/y. While this is consensus, we believe the RBA’s reaction to such a print will be more dovish than market pricing implies. With no signs of domestic price pressures from the labour market, the RBA needs to import inflation from abroad. But the Aussie is unchanged since the last cut in early May, both against the US dollar and in trade-weighted terms. The RBA knew at the time that the envisaged 0.5% rise in core inflation back to target required a permanent depreciation of at least 10%. The dip in May was too transient and shallow to have any meaningful pass-through to inflation, and the Bank thus remains behind the curve.
Second, after widening in June and early July, the 10Y yield spread to the US has narrowed again to 35bps, implying bond inflows will drop sharply based on the historical relationship (chart 1). As foreign direct investment shows no signs of picking up, this means Australia will struggle to finance its current account deficit, irrespective of a potential downgrading by S&P in the coming weeks. And with the risks around the FOMC stance being skewed to the hawkish side going into the autumn, yields should also converge from the US leg.
Third, positioning and valuation still favour shorts. Positioning data from last week’s IMM report, which captures the post-RBA minutes selloff, still show a large extension in net AUD longs (chart 2). That position is at risk of a rapid reversal if the RBA displays greater urgency in easing than the market expects, especially since longs are concentrated in the leveraged community seeking short-term carry rather than value. Indeed, there’s no value to be had as the Aussie remains the second-most expensive currency in the world after the RMB. And the on-going devaluation of the latter, lastly, continues to put pressure on iron ore prices. Stay short AUD.