Questioning the AUD’s non-mining narrative

Posted on December 3rd, 2015

The match has started and Fed Chair Yellen has played to script setting up the case for a stable to firmer USD. Pre-match jitters remain over the ECB, but the case for decisive action was bolstered by weak inflation data. We expect Draghi to act forcefully and we remain bearish on EUR.  GBP has succumbed to lost yield advantage over the USD and is expected to continue to be weighed down by association with the EUR.  The non-mining recovery narrative supporting the AUD has been questioned by the services sector PMI and recent housing data.  Its trade-weighted index has advanced significantly and the currency may now appear expensive.


Yellen plays to script, now its Draghi’s turn

The match has started and Fed Chair Yellen has played to script setting up the case for a stable to firmer USD, reaffirming that the outlook currently supports a rate hike in two weeks, but the Fed will proceed cautiously and slowly with future hikes.

But the pre-match nerves continue with some wondering if ECB President Draghi is going to turn up to play. The Financial Times in the UK has pondered the possibility that Draghi will table a more modest set of further policy easing steps than expected by the market, to appease a small group of hawks and avoid one of them calling for a formal vote that might highlight a sense of disunity in the governing council.

Resistance will come from the governing council’s German contingent of Bundesbank president Jens Weidmann and ECB board member Sabine Lautenschläger, and the heads of the Estonian, Latvian and Slovenian central banks. ECB board member Yves Mersch and governor of the Dutch central bank, Klaas Knot could also object.

Complicating the ECB president’s task, these possible dissenters (7) are all among the 21 council members that hold voting rights at this month’s meeting.  And the four members of the 25 person council that do not vote this month would have been expected to support Draghi’s call for decisive action.

If a formal vote was called, Draghi would probably have to disclose this in the press conference and he might prefer to simply state that there was broad support from the council.

It is an interesting theory, and one that plays to the pre-match nerves. However, it remains the case that Draghi should be able to comfortably find the support of the majority of the council and he has made a clear call for significant further action to push inflation up sooner.  It is still more likely that he uses this moment, as he did in January, to exceed market expectations of further policy easing.

According to the FT article, UBS bank estimates that a 15bp cut from -0.20% has been priced into the market.  I am not sure where this measure is derived, but looking at overnight interest rate swaps it appears to me that the market is only pricing in a 10bp cut tomorrow, although it has rates falling a further 5bp by around Q3 next year.

In any case, rates across the EUR curve have fallen sharply over the last month, diverging from US rates that have risen.    The 2yr swap spread in favour of the USD has widened to 115bp, with US 2yr swap rates firming recently to a high for the year of 1.0123% and Euro 2yr swap rates falling to a record low of -0.138%.  This is the widest differential since 2007, and may be more potent since EUR rates are outright negative.

The EUR has fallen significantly in the last month from almost 1.15 to around 1.06 since mid-October, in response to this spread widening against the EUR, but it is still above the lows earlier in the year.  It seems that the main impediment to lower levels in the EUR at this stage is market positioning close to the year-end.  But even as confidence in the Eurozone economy grows and helps buoy global risk appetite, the market may increasingly look to fund investments (both inside Europe and out) by borrowing EUR for the purpose of yield enhancement and the prospect of exchange rate gains.

On the eve of the decision, the resolve of Draghi to respond forcefully at this meeting may have been bolstered by the weaker than expected core CPI reading that fell from 1.1% to 0.9%y/y in the advance November reading.  Draghi expressed concern over weaker emerging market growth in October and lower oil prices, and these remain significant elements that support his case for decisive action.  If growth and inflation expectations have been bolstered in the last month, much may have to do with the fall in the EUR that has arisen in response to the ECB’s call for action six weeks ago.  The ECB will know that to sustain this improvement, it now need to at the least deliver what the market anticipates, a broad-based set of actions including a rate cut and more QE.

We doubt that further policy easing by the ECB will disappoint relative to modest expectations. In any case, if further policy easing does underwhelm, the bounce in EUR is likely to be short-lived and relatively modest.

GBP succumbs

We had noted some weeks ago that US 2yr swap rates had risen above UK 2yr swap rates as the market absorbed a somewhat less hawhish BoE at its inflation report released on 5-Nov, anticipated a countercyclical capital buffer on banks announced on Tuesday to be implemented from March next year, and the drag on yields and economic outlook from a weaker EUR.

Overnight, the GBP appeared to succumb to these developments along with recent economic data releases that support the notion that the BoE may wait for longer to raise rates.

The Shop Price Index does not normally receive a lot of attention, but it has fallen significantly into negative territory, especially for non-food retailing, suggesting downside risks for core inflation.  The construction and manufacturing PMIs, while still in growth territory, both fell more than expected, suggesting the pace of growth is moderating.

GBP/USD broke below recent lows around the psychological 1.50 level, reasserting a downtrend. Given the 2yr rates spread is at its lowest level since 2006, and flipped in favour of the USD, the risk is still lower.

Doubts in the strong non-mining narrative may stall the AUD rebound

The AUD Trade-Weighted index in trading near its high since mid-year, suggesting it is getting back to levels to consider selling the currency.  The economic reports on Thursday start to question the narrative of a strong non-mining sector.  The services PMI fell for a third month back well below 50, and new home sales fell significantly for a second month in a row to a low level in over a year.  Recent house price and building approvals data concur that housing market activity is peaking. The trade balance also showed the wear and tear from falling terms of trade posting a $A3.31bn deficit in October.


What they said

Federal Reserve Chair Janet Yellen

  • “On balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market. And, as I have noted, continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2 percent objective over the medium term. That said, between today and the next FOMC meeting, we will receive additional data that bear on the economic outlook. These data include a range of indicators regarding the labor market, inflation, and economic activity. When my colleagues and I meet, we will assess all of the available data and their implications for the economic outlook in making our policy decision.”
  • “The Committee anticipates that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
  • “The marked decline in the neutral federal funds rate after the crisis may be partially attributable to a range of persistent economic headwinds that have weighed on aggregate demand. These headwinds have included tighter underwriting standards and limited access to credit for some borrowers, deleveraging by many households to reduce debt burdens, contractionary fiscal policy at all levels of government, weak growth abroad coupled with a significant appreciation of the dollar, slower productivity and labor force growth, and elevated uncertainty about the economic outlook.12 As the restraint from these headwinds further abates, I anticipate that the neutral federal funds rate will gradually move higher over time. Indeed, in September, most FOMC participants projected that, in the long run, the nominal federal funds rate would be near 3.5 percent, and that the actual federal funds rate would rise to that level fairly slowly”
  • The Economic Outlook and Monetary Policy, Chair Janet L. Yellen, At the Economic Club of Washington, Washington, D.C –


In the News


Economic news

  • Australian PMI services fell from 48.9 to 48.2 in Nov. This is the third fall in a row since the index rose to a record in data available since 2010 of 55.6 in August.  The data is seasonally adjusted and starts to put a dint in the view that non-mining sectors are gathering momentum.  The three month average is 49.8.
  • Australia: New home sales fell 3.0%m/m in Oct after falling 4.0% in Sep. Sales peaked in April this year, and have fallen to a low since Sep-2014.
  • New Zealand: value of building construction rose 0.5%q/q in Q3, significantly less than 1.8% expected, after rising 1.6% in Q2. Non-residential building fell 2.6%q/q, residential building rose 2.9%q/q.  The data will dampen somewhat GDP forecasts due in 2 weeks.
  • USA MBA Mortgage approvals for the purchase of homes has risen in recent weeks to around the highs in the last six years since the global financial crisis, fledgling evidence of a rising tend developing that may support the housing market recovery.
  • USA ADP Employment report private payrolls rose 217K in Nov firmer than 190K expected up from 196K in Oct, revised up from 182K. The data will support expectations for a strong government payrolls report on Friday.
  • USA Unit Labour costs were revises up to 1.8% q/q saar in Q3 from 1.0%, above 1.4% in Q2. ULC rose 3.0%y/y, up from 2.6%y/y in Q2.  The series is volatile, but may be a factor contributing to a higher inflation outlook.
  • USA Fed Beige Book economic activity increased at a modest pace in most regions. Conditions in the manufacturing sector were mixed in recent weeks. The strong dollar, low commodity prices, and weak global demand were named by several Districts as factors for constrained demand. Labor markets continued to tighten modestly. The modest pace description has been in place for the last three BBs, and suggests that the Fed will be cautious about follow up rate hikes after a probable hike in December.
  • Eurozone CPI inflation core measure slowed from 1.1% in Oct to 0.9%y/y in Nov advance estimate, below 1.1% expected. This returns the core measure to its rate in Sep, still up from the record lows of 0.6% in Mar/Apr.  Headline inflation was steady at 0.1%y/y, below 0.2% expected.  The data clearly give ammunition to the doves at the ECB to proceed with policy easing as heralded in the Bank’s 22 October meeting and various speakers over recent weeks.
  • UK PMI Construction fell from 58.8 to 55.3 in Nov, weaker than 58.5 expected. This is the second fall in a row to a low since April this year, and well below the peaks above 64 in 2014.  Still growing solidly, but momentum may have eased.
  • UK Shop Price Index fell 2.1%y/y in Nov, down from -1.8%y/y in Oct. This revisits the low in March, the low in data back to 2007.  The non-food component fell 3.3%y/y a low since July-2014.  The data tracks retail outlets and suggests underlying inflation remains low.