Time to sell the AUD

AUD is the currency with possibly the best fundamentals in the world.

Australia is the provider of raw materials to commodity-hungry Asia - China in particular. Aussie exports grew from 108bn in 2003 to 231bn in 2010 and around two-thirds of the exports are commodity related (iron ore, coal, fuels, metals). Thank you China, Japan and south-east Asia.

The AUD is also one of the highest yielding currencies out there. With 4.75% on the overnight rate, it's the highest in G10 and only a handful of emerging countries offer higher nominal interest rates (Brazil, Indonesia, Turkey). In real terms it's also comfortably positive at around 200 basis points over inflation, beating most of its Asian neighbors and most, if not all, other developed countries.

So why do I think AUD is a short now?

The first reason is a likely slowdown in China. As the western deflationary fears hit Chinese shores in 2008, the authorities embarked on an unprecedented credit creation exercise. As has been pointed out before, the money supply created in the middle kingdom was higher than the monetary stimulus in the US, UK, Eurozone and Japan combined (in USD terms). I'm nore sure if this still hods true post-QE2, but the point is that what the Chinese did was money creation on an extraordinary scale.

The party was great fun. The funds fueled an investment boom, which in many ways worsened imbalances in the country (too much investment and too little consumption) and abroad (on the trade front). However, as all parties, it eventually comes to an end. No country can sustain 40% M2 growth for very long, and now we are entering the most delicate stage of the credit cycle: when the rate of growth of money slows. There goes a graph from our friends at Nomura to illustrate the point:


So the worry is that as China is slowing (as it's visible in PMI and industrial production numbers in recent months), it's appetite for Australian commodities will diminish slightly - or at least will not grow as fast.

The second reason for shorting the AUD is a mix of valuation metrics, and the impression that the currency has diverged.

The first chart shows a simple AUDUSD regression model using interest rates, commodity prices and a Chinese growth indicator. Clearly there is a gap here. Maybe it's a structural break... maybe not.


The second chart is a similar model for AUDCAD (two commodity currencies - we take the US dollar out of the equation), which forecasts the AUDCAD rate 12 month forward. Although in 12 months the forecast AUDCAD level is roughly at where we are today, the current divergence points to around 10% AUDCAD overvaluation in the next couple of months.


Finally, this is a trading call. The longer-term fundamentals for the AUD are quite good, but it is a very cyclical currency, and looks too frothy now, given the downside risks to Chinese growth.