AUDNZD - How Much Can It Run?

As I toil during these Asia market hours, I thought it would be good to do an Asian market piece.

AUDNZD has been in my interest since its initial bottom in mid-2014.  Historically speaking the pair's movement is reflective of the business cycle differences between the two economies. We have bounced off historical lows both in nominal terms and real terms.

What caused this move off the lows? Can this bounce continue? Or is it time to be a Dodger's fan and leave before the trains start running late or the traffic gets too bad ;)

I have distilled that into a few focused factors that I believe are important for AUDNZD right now.

AUDNZD has been recently trading off the terms of trade differential between the two countries that disregarding the potential housing bubble aside, the economy in Australia looked much more favorable than that of New Zealand – something that AUDNZD has yet to price correctly.


One of the main things I’m looking at here is the divergence in Australia’s and New Zealand’s respective terms of trade. There has been a strong correlation between the two country’s terms of trade and their currency levels. The rising prices for Australia’s commodities have been driving by the huge rebound in metal prices (20% to 25% of Australia’s exports = iron ore, the price of which has risen precipitously). 

As you can see this signal isn’t always a focal point in driving returns, but I believe moving forward, it will matter. 

However, base metal prices have failed to maintain these current levels, as the Trump/populist trade unwound somewhat in the past few weeks. On the other hand, milk futures prices seem to be establishing a bottom. It’s reasonable to expect an appreciation of AUDNZD to come to a halt as well. But if the fortunes of those two commodities groups reverse.....well I’ll leave that to your imagination. 

With that said, we are at a good risk reward point in terms of relative economy performances.

NZ has experienced growth and inflation after the RBNZ lowered rates after the Christchurch earthquake in 2011. After experiencing growth, they were the only major central bank raising rates back around ~2014.  AU has been relatively more stagnant, however, after having relatively lower rates since mid-2014 is starting to pick up.

Looking at relative unemployment rates, we are at a local low of NZ minus AU unemployment (higher unemployment rate in AU than NZ) and have to start to trend the other direction. Ultimately, from a trades perspective, New Zealand is strongly dependent on Australia (~19% of total trade) but the reliance is non-existent the other way around (~3%). One could interpolate from this relationship that New Zealand, with their higher interest policy,  will soon start to feel some of the economic pains that Australia has had to deal with in the last couple of years.

Additionally, looking at the respective central banks’ posturing: both central banks are in easing cycles, but it is clear that NZ has been doing the catch up since 2015. The central bank rate differentials using AU minus NZ should that AUDNZD should be higher, especially if the trend continues of the RBA starting to taper and RBNZ continued to need to weaken its currency, the story is also true for approximate real rates for the two countries as well (generic government bond rates minus inflation). 

I also built a real rate spread using extrapolated CPI and government bond yields (to calculate a real rate). This does show that there continues to be a break between AUDNZD and real rate differentials

With the above highlighted, it is easy to imagine that AUDNZD presents a lot of value. Looking at the pair in real terms – NZD still hovers around historical levels, potentially prompting more action from the RBNZ while the AUDNZD real rate is near historical value territories.

From a positioning perspective – using CFTC FX futures positioning, it's starting to look stretched from a long AUD vs short NZD perspective.

So now what?

I think from the rate's and central bank's perspectives, there still seems to be a disconnect between the rate markets and AUDNZD. We could be witnessing the long term bottom of AUDNZD as the business cycle slow shifts to a long-term bottom for base metals and energy. 


However, after the explosive move driven by the rise in inflation and yields (derivative effect evinced through rising base metal prices), we could possibly be in a position of over extension of those metal prices. If we pullback in metals/inflation (I think we can pull back), so can AUDNZD.


Unemployment differentials show a clear bottom, but no clear strengthening in Australia vs New Zealand. Risk reward is to be long that chart and thus AUDNZD.


Finally, positions seem a little stretched at this point, but obviously, this doesn't necessarily have to be the utmost driving factor.


Conclusion:


I think it's okay to be a short term dodgers fan and book some profits for now. But as AUDNZD pulls back between 1.05 and 1.06. I would look to rebuild or add to a long position.



Thanks guys, good luck tomorrow with the jobs number. Been really busy of late - will do some work on US equities + Wars - look out for a Syria piece this weekend!