Why has the Australian dollar been so strong? !
BofA with an interesting take. Fair enough, I think. Except on one point. As the Fed smashes the US economy and an epic inventory destocking event begins, China will be completely skimmed in 2023.
AUD weakness has been resilient all things considered
AUD/USD is at new lows against the USD with the 0.60 low matching the global “crisis” levels of October 2008 and March 2020. However, the bilateral exchange rate distorts what has been remarkably resilient in trade-weighted terms in the face of the massive Chinese import squeeze. and concerns about the global recession (chart of the day). The positive terms of trade shock partly explains this, but so do the structural changes in the Australian BoP which may be more durable over time. As a result, while AUD/USD remains vulnerable to a global slowdown, AUD crosses should hold up better – AUD/NZD fair value, for example, rose above 1.15.
AUD weakness is misleading
As global recession fears mount, commodity currencies have unsurprisingly faced the brunt of this pessimism. The AUD is no exception, reaching new lows against the USD with the 0.60 low corresponding to the “crisis” levels of October 2008 and March 2020. However, due to Overall USD strength, the bilateral exchange rate distorts what has actually been a noticeable resilience in the AUD, all things considered. Consider the following:
• Despite its recent fall, the AUD is still the third best performing G10 currency (excluding USD) since the start of the year after the CAD and the CHF.
• As a result, the RBA’s trade-weighted AUD index has remained in a wide range (60-65) since June 2020. Looking at the TWI ex-USD, the AUD is actually 2% stronger year-to-date and well above historic crisis levels (Exhibit 1).
• AUD/JPY, the classic global growth proxy, remains close to all-time highs despite the recent pullback. This is largely related to the depreciation of the JPY due to policy divergence, but also reflects the resilience of the AUD.
• Chinese imports from Australia have collapsed due to the slowdown in the real estate market. In past episodes of negative Chinese import impulse – particularly in 2015-16 and 2020 – the AUD TWI has weakened by at least 5% YoY. In contrast, the AUD held up well in the latest crash (Figure 2).
The AUD outperformed its implied PCA move (as did the NOK)…
We update our Principal Component Analysis (PCA) approach to quantify the AUD’s outperformance. We apply PCA to G10 pairs (against USD), extracting three components that explain the bulk (94%) of the co-movement between exchange rates. Since these are “drivers” affecting all currencies, we assume that they reflect external factors. Examining the simple correlations of these components with market prices allows us to infer the underlying fundamental drivers, which we previously identified as the US dollar, risk and rates.
Figure 3 compares the actual and estimated performance of G10 pairs from May 30 to October 7, 2022, using weekly data. Estimated performance is out-of-sample, based on the individual betas of each G10 pair against the USD against the three PCA components since 2010. While the NOK and AUD have weakened, the depreciation has been well below what their historical betas would imply. This is probably related to the positive terms of trade shock for these countries, which is not directly taken into account by the PCA factors. Our constructive view on energy prices, for example, is part of why we are constructive NOK despite this
… but this may be due to structural and lasting BoP changes
The surprising resilience of the AUD raises the question of whether it reflects temporary or long-lasting factors. The terms-of-trade shock discussed above is arguably most at risk if China remains weak and/or global energy prices fall – indeed, China’s terms of trade Australia have deteriorated over the past month. However, we expect the momentum from China to be more supportive as 2023 approaches (Figure 4). Additionally, there are potentially long-lasting structural shifts in Australia’s balance of payments (BoP) that suggest the AUD’s trade-weighted resilience may persist.
• China matters, but our economists have underscored the diversified nature of Australia’s boom in goods trade (The Diversified Trade Boom August 16, 2022). Energy export earnings (primarily coal and LNG) now exceed iron ore, while exports to other major Asian economies now exceed China (Figure 5). This is the main reason why the collapse of Chinese imports from Australia weighed less on the AUD compared to previous episodes.
• Trade diversification extends beyond exports of goods. The pandemic disrupted a trend increase in Australia’s services exports, with its share of total exports falling from over 20% to less than 10% in June 2022 (Figure 6). But that has started to pick up with the reopening of borders – while the recovery will be gradual and partly driven by China’s reopening to outbound travel, it will provide further diversification to the global manufacturing cycle over time .
• Australia’s international external position is critical: at -34.2% of GDP in 2Q22, the NIIP is at levels last seen in the 1980s. This improvement is the result of large current account surpluses during the last years. But the composition of this increase is critical – the recycling of current account surpluses into foreign equities (mainly by pension funds) lifted the net external position in equities to +14.8% of GDP, having more than doubled in course of the last three years. Australia’s net creditor position in equities may also explain its trade-weighted resistance to the global equity sell-off.