AUDNZD Revisited - Inflation and A Berning Socialist Experiment

First of all, sorry for this slightly outdated post, but I wanted to go through with it as it is something I've been trying to get off my plate for a while...

Good old AUDNZD...it seems like forever since this pair has been floating around the cellar of its historical range.

I've written about this pair in the past here (we could've caught some small moves in the past, I am still swimming in this ocean looking for the big fish of a return) - the large range that it trades between is largely reflective of the business cycle between the two countries and the close tie between the two economies (although that link is largely a one-way street where New Zealand depends on Australia)

As the market slowly starts mulling over the possibility of rising inflation - I had the crazy idea that going long the pair can be a viable and innovative way to express that exposure.

First thing's first: why would it reflect an exposure of rising inflation?

Like we've detailed in the past, the pair trades closely in line with the relative terms of trade between the two countries.




So let's extrapolate that - if you have a bull market in commodities what would happen?

Well, back in 2005 - 2011 when we had a bull market in almost all commodities, AUDNZD traded up to historical highs of the range - yes, agricultural products were in a bull market as well.


If we were to have a repeat of this type of inflationary pressures (the bull market for energy, metals, and grains), I would speculate a similar response for the commodities index as well as AUDNZD.

In addition, there are a couple of recent developments that I find interesting here:

The fundamental trends between the two countries' economies continue to trend favorably of a higher AUDNZD (from historically bad levels). Furthermore, divergence in Central Bank action as well as some very interesting political developments in New Zealand and the RBNZ that can potentially be very impactful.


Looking at this further:

1)  Let's look at some other fundamental factors:

The economy through the lens of unemployment has been in favor of New Zealand over Australia for the better part of almost 4 years. It seems to have stabilized - with the way the global economy has started to grow, I would think the "worst" has been priced in.




Looking at the rates market with inflation accounted for we have started to see a bottom and a divergence between the two countries if we don't get a horrific outlier of a miss.



*Real rates calculated via extrapolated CPI.


**Using AU CPI print projected at 0.8% from Westpac

I assume a continued divergence would lead to eventual central bank action:




2) The Bernie Sanders experiment is officially underway in New Zealand.

The newly elected prime minister of New Zealand, Jacinda Ardern is described as the following:

-Political allies NZ First (a socially conservative party with a hint of xenophobia) and the Greens (your stereotypical green party)

-Wants jobless rate to fall to 4% from 4.8%, in turn probably support reform the RBNZ (Link) to focus on not only inflation but also full employment

-Doesn't like immigration, blames it for rising housing costs

-Wants to restrict trade

To me, she does not remind me of Macron or Trump as some media outlets have stated. To me, she's much closer to Bernie or Elizabeth Warren, especially when it comes to the economic policies.

New Zealanders, are you ready to feel the Bern?

Since Ardern is set on forcing the rate of unemployment lower, and the finance minister has explicitly stated the intention to have the RBNZ change its focus to include full employment, it is probably to assume that their next Governor appointment will focus on pushing through said agenda.

The full employment and low and steady inflation dual mandate are comparable to that of the US Fed - the two mandates contradict each other: if there is true full employment, inflation would be ripping; if there is low and steady inflation, chances are you are unlikely at true full employment.

The two dynamics demand some favoritism towards one. I would assume the favor would be towards unemployment with Ardern. 

What does that mean? Well looking at WIRP at the end of the year in 2017 (apologies for the outdated data), it seems that the market is suspecting that there will is a 75% chance for a hike in 2018 despite the RBNZ explicitly stating that they will keep rates lower for the next two years! Depending what the market prices throughout the year, there could be good risk-reward for a fade.

I would deem the risk of a hike as overpriced.



In addition, revisiting the fundamentals above, it wouldn't surprise me if they actually lowered rates before they raise them. From a historical perspective, it wouldn't be out of the question.

On the other hand, Australia WIRP at the end of last year was pricing in the similar odds for a hike as New Zealand. The differences here is where I think presents the opportunity. Ultimately, this economy is one that is trending upwards from lows and can get a push from rising metals and energy prices - especially if you buy into the concept of higher inflationary pressures.

Contrarily, I would deem the risk of a hike underpriced here.



Conclusion:

I believe AUDNZD looks like a good way to short NZD and express a long overall inflation view. To purely play the developments in New Zealand, trading the short end rates curve in NZD is also another way to potentially play it. However, if I recall correctly, NZD rates were relatively illiquid. To purely play the inflation view, one can always simply go long AUD by itself, but you expose yourself to USD risk. In my opinion, the fact that the pair is near the bottom of the range introduces convexity to the trade.

What can go wrong:

AUDNZD obviously has both the Aussie and Kiwi components - I believe if inflation rises, one can potentially make money on the trade even without the NZD scenario of the RBNZ lowering rates materializing...However, if I am terribly wrong regarding the Australian economy and/or rising inflation, you can be at risk as well for your Kiwi view. Conversely, if I am terribly wrong about New Zealand, you can be at risk for your inflation view.

Decisions, decisions. A decision that I'll leave up to you.

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johno
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January 31, 2018 at 4:10 AM ×

Ambivalent on AUDNZD here. Agree there are lots of reasons to be bearish NZD, but none some to matter to price right now. Maybe it's a story that needs to unfold over more time, and we're just thinking over different horizons.

Flat in USD. Just don't have a view on a catalyst, other than maybe cessation of month-end hedge re-balances, but that's not argument enough for me. USDJPY can't even get a decent bounce out of stocks rallying from the open in Asia and the BoJ increasing the size of its bond buying for the first time since July.

Sold my April VIX futures earlier today. I figure you don't go from massive bullishness, bidding stocks up 0.4% every trading day for 3 1/2 weeks to panic selling. People are sitting on huge YTD profits and it's way too early in the year for people to be locking them in some panic.

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IPA
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January 31, 2018 at 5:13 AM ×

Yes @johno, them equity boys are too afraid to miss another FANG party. If NFLX is a template, the group will rally for a bit. Let's see how high they go on a bounce. My crystal ball is foggy here until one of the following happens: 1) NQ breaks 6924 on daily closing basis with a vengeance, 2) NQ makes a new high (on very narrow breadth) and reverses to form some kind of crazy bearish daily/weekly candle, and 3) NDX cash closes a gap and reverses lower (less of a signal but more of a pattern that is likely if FANG rally stalls shortly after earnings). Until then, I sit and watch how the party unfolds. I'd like to see more divergence from SOX as well. It is anticipating some kind of pause for sure and seems to predict the NDX decline by about three days. I also should note that this is a historical rally and may not have the same signals, decline patterns, and/or usual behavior we associate with bull market corrections. I laugh at these predictions of 5 or 10 percent declines to have a "healthy reset". Yes, the heard of fleeing bulls will magically stop at a certain level. Ludicrous!

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Leftback
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January 31, 2018 at 6:59 PM ×

Dame Janet's final statement.... in 3. 2. 1....

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Leftback
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January 31, 2018 at 7:16 PM ×

....and even the FX market thinks that was a gigantic Nothing Burger.

We are now trading Friday's jobs release, presumably, and we have already had the now-traditional "hot ADP number". Now watch spellbound as "earnings growth disappoints" and "headline number misses" due to "weather" and "seasonal factors" despite "solid economic fundamentals" "tight labor markets" not to mention "animal spirits" and "small business optimism". In the real world of things that can be measured, don't be surprised to see a slowdown in construction, the recent tax changes and higher mortgage rates are already beginning to bite into the higher end housing market in some places.

The end of the week might see some profit taking in a few of these crowded trades: short USD, long EUR, and short Treasuries.

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Leftback
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January 31, 2018 at 8:16 PM ×

Here's a thought experiment for you: gaps in charts are often filled. Given the contribution of AAPL to the indices, that chart has considerable significance. Because, passive peeps, you own AAPL. Yes, you, Grandpa, and all the 12y-o HF managers.

AAPL has a gap around 157 and another near 150. Currently trading at about 167. Usually when AAPL earnings are released, the stock gaps up and the index ETFs grind higher as the CNBC presenters squeal and shorts experience rectal discomfort.

Now imagine, if you will, that AAPL release a real stinker one day. Not saying this will happen tomorrow, but it will happen one day. Why? Well, because it's not a magic money machine, it's a company that sells stuff, sometimes less stuff than punters anticipated. Active funds would then be keen to unload the stock, and the ETFs would be FORCED to follow suit and that drives volatility higher, which begets further index ETF selling, trailing stops and sell programs get activated, and before you know it, whoa it's down 6% AND yes, one of those LOWER gaps gets filled.

Over in Asia, all of the AAPL suppliers and semiconductor stocks get hammered overnight. Shanghai and Tokyo have a mini-meltdown. The usual Asian contagion happens, with JPY and USD bid and AUD, KRW and everything else being offered.

Grandpa, and all the 12y-o HF managers wake up the following morning to find the Spoos are down 30, 50 handles and the market isn't even open yet! When the market opens, a number of participants find that their positioning is less than ideal, and a large spike in vol develops which unwinds a number of leveraged positions during the day until AAPL is off 10% and the other gap has been filled. All of this is predictable at some point, given the present relationships between AAPL, SPY and the VIX. The latter are derivatives of AAPL, to some extent.

February, May, August? A whole new generation of investors will one day get to experience the joys of Global Gap'n'Crap.

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Leftback
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January 31, 2018 at 8:44 PM ×

Finally, Yield Watchers Anonymous reports on the return of The Flattener:

2s10s - 58 bps. 5s 30s - 43* bps. 2s30s - 81* bps.

* New cycle lows.

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johno
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February 1, 2018 at 12:33 AM ×

Interesting scenario, LB. A reminder to have AAPL earnings announcements on the macro calendar. I actually sold my AAPL a couple weeks ago. Mature, slow-growing market. Chinese smartphone demand actually DOWN last year. AAPL valuation not demanding though, if one thinks margins sustainable ... if.

Still waiting for the dollar catalyst ...

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IPA
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February 1, 2018 at 1:34 AM ×

Let's try this again. I am in the first scale-in of WTI short right here with targets of 62, 60, and 58. Stop above 1/25 high and I would like to add on a possible break of 64.50

@LB, let them celebrate the FANG earnings. One more push higher...

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mozav007
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February 1, 2018 at 2:58 AM × This comment has been removed by the author.
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mozav007
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February 1, 2018 at 7:37 AM × This comment has been removed by the author.
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