In our previous take on the Australian dollar in late February, we wrote that falling commodity prices, an ongoing slowdown in China, and weak domestic conditions (looking at both economic data and monetary policy expectations) were significant headwinds for the currency. Beyond economic indicators, quantitative signals also suggested that the bullish trend was running out of steam. We downgraded our outlook on the currency on March 19. Since that time, the Australian dollar has weakened significantly against most major currencies.  

Looking to the future, there is little to celebrate. While the currency is likely to enjoy a short-term relief rally (as the Australian dollar has entered oversold conditions today), economic conditions remain worrisome. The biggest issue is that Chinese growth is more clearly decelerating from its peak last year, and this is weighing on commodity prices. As commodity prices reverse, we expect the Australian dollar to weaken much further over the longer term.

As Chinese growth decelerates, Australia looks vulnerable

The Chinese economic cycle drives Australian commodity prices for two reasons: (1) the country frequently launches significant debt-driven stimulus programs, and (2) Chinese domestic investments are focused on physical infrastructure. As an exporter of commodities such as iron ore, copper, thermal coal and coking coal, exports from Australia are in high demand when China launches a stimulus program. In recent history, China has launched stimulus programs in 2011 and in early 2016. This can be seen more clearly below:

Past the peak: commodity prices and producer prices both decelerating

(Click on image to enlarge)

Source: RBA, China NBS, MarketsNow

Looking at the peaks and valleys in the chart above, the timing and scope of China’s most recent stimulus programs are fairly obvious. The RBA Commodity Index (a measure of prices weighted by specific commodities produced in the country), shoots up when the country’s commodities are in high demand from Chinese buyers. Unsurprisingly, Chinese producer prices also shoot up when the government is stimulating the economy, as input prices (such as commodities) become more expensive.

As a commodity currency, commodity prices are the dominant factor in determining the value of the Australian dollar. While Chinese stimulus helped the Aussie between early 2016 and late 2017, the inevitable downturn will weigh on the currency going forward. After Chinese producer prices accelerated to 7% and the RBA’s measure of commodity prices surged to 55% last year, upcoming figures this year are likely to be negative. Beyond the issue of base effects, China has hesitated from launching another significant stimulus program given its massive debt-based spending spree in recent times and the country’s rising overall debt load.

US dollar resurgence limits benefits from China’s last stimulus program

When China launched its first stimulus program following the 2007-2008 crisis and its second program in 2011, the country was widely lauded for helping global growth. As the Federal Reserve was engaged in significant quantitative easing at the time, investors chased riskier investments while the US dollar languished. As commodities are primarily traded in dollars, commodity prices (and the Australian dollar) surged to multi-decade highs. Looking at AUD/USD specifically, the pair traded near highs last seen in the early 1980s.

While China’s most recent stimulus program in early 2016 was as large as its previous efforts (according to official NBS data), the Australian dollar did not rise to its previous highs from earlier in the decade. This time, the Federal Reserve had stopped quantitative easing and instead signaled a series of future rate hikes, helping the US dollar to strengthen. This hurt the commodity market rally and commodity currencies. A comparison of AUD/USD to iron ore prices is shown below for reference:

Third time’s (not) the charm?

(Click on image to enlarge)

Source: ICE, TradingView, MarketsNow

As can be seen in the chart above, AUD/USD and iron prices are closely correlated (for reasons described above). Between early 2016 and 2017, iron ore and the Australian dollar failed to achieve their respective previous highs from the 2011-2013 era. As the effects of China’s 2016 stimulus program wane this year, iron ore and the Australian dollar have both entered a bearish trend.

As the Fed continues to tighten monetary policy (a risk we described in a recent commentary on gold), the US dollar is likely to remain supported. We ultimately expect the US dollar to strengthen later this year, as global growth decelerates while speculator positioning in “short dollar” trades approach bearish extremes. This is bad news for commodity prices and the Australian dollar, as both may fall to prices significantly below the previous long-term low in early 2016.   

A weak rebound followed by a long way down

Despite an uptrend since early 2016, the AUD/USD has only registered moderate gains. From its trough around 0.69 (January 2016) to its most recent peak around 0.81 (January 2018), 17% gains (excluding interest) are fairly insignificant for a boom-and-bust currency like AUD.   

While this week’s Australian dollar sell-off is looking overdone, the longer-term downtrend can go a lot further. Ultimately, the Aussie tracks the fortunes of the Chinese economy, and there are few reasons to believe that Chinese economic growth is set to accelerate in 2018. As commodity prices are handicapped by a rising dollar, commodities can also fall a lot further. Beyond the dynamics of a Chinese slowdown and an accompanying fall in commodity prices, Australia also suffers from obvious issues including highly indebted households and a significant housing bubble. While Australia’s weak finances have been overlooked in the recent “bull market”, investors will not be so kind in a downturn. While going long the Australian dollar only generated small returns by historical standards, going short the Australian dollar is looking more and more enticing.