Aussie Aussie Aussie Oi Oi Oi

While it is often tempting to suppose that a country's sporting success (or failure) can have a market impact thanks to some sort of knock-on effect to consumer sentiment, there is little evidence to support the notion.  It's true, for example, that the Brazilian real has been pummeled since the Selecao's humiliating exodus from their own World Cup last year...but that ignores the fact that the BRL was pretty stable in the low 2.20's for a couple of months after the loss to the Germans.   Similarly, there has been no notable knock-on rally in the NZD after the All Blacks' defeat of their antipodean neighbours in the Rugby World Cup Final...not has there been any weakness in the Aussie at the time of writing.

Speaking of the Aussie, the RBA meets this evening , and the market reckons (at least judging by the pricing) that there's a decent chance of another easing.  To be sure, inflation remains below the Bank's 2-3% target after last week's disappointing CPI, and commodities are not exactly offering any sort of support to the notion that we're not on the downswing of the supercycle.  As such, markets are looking for nearly 50 bps of easing by next (Northern Hemisphere) summer.

However, there are also reasons to think that the RBA could stand pat.   As noted on Friday, credit growth is now at post-crisis highs, albeit at substantially lower levels than before the GFC.  However, it is not immediately obvious that a return to 20% plus credit growth would an unalloyed positive...or any sort of positive at all.   The secular rise in household debt as a percentage of income is little short of stunning; ironically, the latest reading (132.8%) is just above the peak in US household debt to disposable income of 132.77 registered in Q4 of 2007.

Now, while the high levels of debt suggest that the neutral interest rate is a lot lower than it was before, particularly given the households' exposure to floating or quasi-floating interest rates, by the same token it is also incumbent upon the RBA to dissuade even further levering of household balance sheets when rates are at historical lows.  This is, after all, an economy that has grown for 24 straight years, and a real policy rate of 0.5% is pretty darned low.

The elephant in the room is, of course, house prices, which have become something of a national obsession during the long economic boom.  Housing in major cities has been extraordinarily overvalued relative to incomes for many years; although lack of adequate supply is the real culprit, in recent years Chinese buyers can serve as a useful scapegoat.   Regardless, after a bit of a wobble  at the end of last year housing seems to have responded to prior RBA easing, and y/y gains are now back in double digits close to their post-crisis highs.

One of the arguments in favour of easing calls has been the "need" to lean against recent mortgage rate rises from some of the large domestic banks.   However, if all you knew was that house prices were rising double digits from an already overvalued level, household debt was at record highs, and that real cash rates were in the bottom 10% of their historical range of the last quarter-century, would you expect a rate cut?

Macro Man would not and does not, though obviously there are other factors that play into the decision.   Unemployment is at 12 year highs, though the rate (6.27%) remains one that many other developed countries would like.   If the labor continues to deteriorate, then of course the RBA could move again.  However, Stevens & co. have made it abundantly clear that they're aware that policy works with a lag, and it seems to Macro Man that they'll be willing to give it a bit more time to see if the unemployment rate stabilizes.

Short Aussie has been and remains a popular trade in many circles; not only has the RBA been easing, but of course there is the commodity and China linkage as well.  However, it seems to Macro Man that much of this is fully priced.   He constructed a simple model to value AUD/USD using 4 inputs:

* The daily CBA Commodity price index in USD, which tracks the monthly RBA version extremely closely

* Australia vs US 2 year swap spreads as a proxy for current and expected monetary settings

* Australia's trade balance, lagged to ensure there is no forward looking data in the regression

* The 3 month change in 3 month CNY NDFs as a proxy for China expectations

Using an in-sample period of 2000-2012, the regression has an r-squared of 0.89; the out-of-sample r-squared is still solid at 0.71, which is good given the breakdown in most of the things that had previously supported the AUD.  For most of the last several years, the model has suggested that the AUD should be weaker than it actually was.  More recently, however, the model has viewed the AUD as fairly priced or even cheap.

While Macro Man wouldn't use the model to market-time short-term trades- one lumpy trade figure can generate temporary spikes- as a sense check it does offer some utility.  Specifically, after showing the AUD as fairly consistently overvalued since mid-2012, the subsequent decline has now pushed it into under- or fairly-valued territory since May of this year.   Obviously, this doesn't mean that the currency cannot or will not decline further...but it does suggest that gains from being short over the next year or so are highly unlikely to be as good as they were for the past 18 months.

From Macro Man's perspective, there are easier fish to catch (cough, euro, cough) than the Aussie at the moment.   It's sometimes easy to forget that in trading, unlike in certain sports, they don't add extra (basis) points for degree of difficulty.