Sunday Edition: My Favorite Long-Term Currency Play

March 12, 2017

Sunday Edition: My Favorite Long-Term Currency Play

Markets are forward looking, and therefore have a way of discounting many fundamental arguments as to why an asset should rise or fall, so that when the “fundamentals” seem obvious, it’s too late as a trader, and often even as an investor to earn outsized gains.

To illustrate my point, I will use an article I came across that was written on October 25, 2016.  Even though the article is now a little over four months old, the basic thesis put forth in the article is still “relevant” to my discussion. The headline from the article follows:

“Australian dollar could be poised for significant drop”

What I find most amusing is that the Aussie had already dropped -38% from a high of 1.10 USD in 2011 to 0.68 USD in early 2016 (now that’s significant), four years prior to the article’s printing.

At the time the article was written, the Aussie was trading at .76c to the USD. Over the next several weeks the Australian Dollar did drop to as low as .71c against the USD before rebounding back to its current level of .75c to the USD.

While a .05 cent (6.5%) move in six weeks is a decent move for a currency, it by no means constitutes a “significant drop.” Especially when you consider that in May of 2016 it had also traded as low as .71c and in the prior month of April, it traded as high as .78c.

In other words, the Australian dollar is/has been range bound between .71c and .78c for the better part of a year – trying to find a long-term bottom in my opinion (more on that in a moment).

Now in all fairness, the author doesn’t appear to be a financial analyst, although he did disclose a short position in the Aussie (I hope he covered quickly).

The general tone of the article was Aussie Dollar bearish, but his opening argument is somewhat “theoretically” bullish in that he argues that “as long as Australia’s official cash rate stays materially higher than the US Fed Funds rate (currently a gap of around 1 per cent), Australian deposits will look more attractive, and foreign investors will buy Australian dollars in order to take advantage of that ‘yield differential’.”

This “theoretically” sounds logical, but the reality is that back in 2011 when the Aussie was trading at 1.10 to the USD, the official Australian cash rate stood at 4.5%, where the US Fed funds rate was a mere 0.25%. Shouldn’t investors have been selling the hell out of the dollar and buying the Aussie with that kind of spread? You would think right? Maybe that’s what they were doing the three years prior as the AUD skyrocketed from .60c USD to 1.10 USD.

Like I said, if you wait until the fundamentals are “obvious” it’s too late. And maybe the -38% crash in the AUD/USD between 2011 and 2016 can be partially explained by the narrowing of the spread between the rate of interest paid on the two currencies (again, very forward looking).

The article then cites rising US rates putting pressure on the Aussie, which might be true if the Fed funds rate were materially higher than Australia’s official cash rate but again, that has not been the case.

For the Fed funds rate to trade at parity with Australia’s official cash rate, the Fed would have to make good on its proposed triple rate hike in 2017 and the Aussie rate would have to stay at its current level of 1.5%.

So without a significant spike in the Fed funds rate, which would be very bad for the US economy, stock market, and probably the US dollar too, as it would most likely mean severe inflationary pressures, I don’t see it necessarily being bad for the Aussie.

The author of the article also saw a faltering Australian economy as a risk to the Aussie Dollar. Australia’s economy is considered a “miracle” economy since it has now gone a record 101 quarters between June 1991 and the 2016 December quarter without two straight quarters of negative economic growth.

I know after 100 coin tosses, all landing on heads, the odds of getting tails on the 101th toss is still a 50/50 proposition and doesn’t increase based on the prior 100 tosses. But in my opinion, a recession in Australia is guaranteed at some point, although I couldn’t say when, because an economy is not a coin toss.

And I don’t believe a recession in Australia would necessarily have a negative impact on the AUD/USD exchange rate. If that argument were true, then why hasn’t the 101 consecutive quarters without a recession been super bullish for the Aussie Dollar? Remember, it has crashed -38% over the last four years – maybe the crash in the Aussie has been predicting a long overdue recession in Australia which is now already discounted in the current price?

Furthermore, between 2000 and 2003 (dotcom bust), the USD appreciated significantly against a basket of foreign currencies, but the increase in the AUD still outpaced that of the USD over the same 3 year period. During the subprime panic the USD also increased against a basket of foreign currencies, but the AUD fell sharply against the USD.

How might an Australian recession affect the currency pair, assuming it was limited to just Australia? How might a US recession affect the currency pair? Who knows, it’s anybody’s guess.

The article then went on to cite an Australian property bubble, rising China debt levels (250% of GDP), developments in the South China Sea, and slowing demand and falling commodity prices as risk to the Aussie dollar.

Of all the arguments, falling commodity prices seems the most plausible to me since 19% of Australia’s GDP is based on mining and agricultural (7% mining and 12% agricultural), which have both been in severe declines.

But because the AUD and commodities appear to have dropped in unison, that’s probably already baked in too. And when you consider that 68% of Australia’s GDP is based on the thriving service sector, it becomes even tougher to pin the entire -38% drop in the AUD/USD on falling commodity prices. Or make the argument that now that commodities are down it will some how cause the Aussie Dollar to continue to fall.

Now, I’m not picking on the author of this particular article, he’s not the only Aussie Dollar bear. The National Australia Bank foreign exchange strategists have forecast the Aussie dollar to drop towards US70c during 2017, and even lower in 2018.

And other economist are predicting the recent rise in commodity prices to reverse and negatively impact the Aussie Dollar.

Is it possible the AUD continues to fall against the USD? Of course it is. My point is that most, if not all the bearish arguments against the AUD are already priced in, and I believe there is a much higher probability that the bearish downtrend that began in 2011 is in the process of reversing as the pendulum begins to swings back the other way.

If I’m correct, a year or two down the road after a significant rise in the Aussie, there will be plenty of “fundamental” arguments as to why it will head higher. Of course that may be the time to exit and take profits.


Chart of FXA courtesy of Trading View.

In the above chart, the 78.6% Fibonacci retracement sits at .71c USD and more or less coincides with the large gap down back in 2008 (green shaded area between .74 and .77).

These are all important psychological levels, that I think are now providing long-term support as the Aussie grinds out a long term bottom.

I believe an asymmetrical reward to risk opportunity lies in getting long the AUD against the USD. You could do this by trading the currency pair or by investing in the Aussie Dollar ETF ticker – FXA.

Disclosure:  I am long AUD/USD.

Regards,

Shane Rawlings
Founder, Investiv

 

By Shane Rawlings Australia Dollar Investiv Daily Sunday Edition Share:
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