The Australian dollar has veered away from its usual path. *Bad Aussie.*
But there is a widespread belief it will have to eventually find its way back. How quickly it does so, however, is open to debate.
The Aussie is a risk-loving currency and, as such, is usually closely correlated with the S&P 500. Of course the Aussie’s value is relative and as such it tracks the S&P index via its relationship with other stores of value — it has to move against something else before it can be judged against the S&P.
Its positive correlation with the index is particularly evident within two relationships: AUD/gold and the S&P 500, and AUD/USD and the S&P 500. In both cases, when there is a risk-on push and the S&P jumps, the Aussie also benefits strongly.
Risk on = Aussie good versus the dollar; and
Risk on = Aussie even more good versus gold (which is the ultimate safe haven and hence is likely to be moving in the opposite direction in a risk-on environment).
As the Aussie benefits versus those two stores, the S&P should be rising and therein lies your positive correlation.
However, that relationship has broken down recently leaving a tantalising gap for correction – particularly where gold is concerned.
The Aussie dollar has fallen over 5 per cent against its US equivalent since the start of the year and suffered its biggest dive in six weeks on Tuesday when the Reserve Bank of Australia cut rates by 50bps. (Markets had only priced in a 33 per cent chance of the RBA cutting that aggressively.)
That overall kick downhill since mid-February has broken the pair’s usual relationship with S&P 500 fairly dramatically:
The AUD/USD move makes sense when seen beside the spectre of a China led slowdown and RBA easing fears, which proved founded in the end. And now the market has priced in another 50bps of cuts to come. As the chart below shows the current RBA cash rate is at 3.75 per cent and the market expects it to decline over the next 18 months or so to close to 3.25 per cent:
The question now, says Evariste Lefeuvre, chief economist with Natixis, is whether the AUD/USD has already priced this next round of easing in — his model suggests the Aussie is already below fair value and he doesn’t see the RBA cutting rates back to their 2009 level of 3 per cent.
(We also note that recent IMF reserves data suggest the Aussie dollar might need to be viewed in a slightly different light from now on anyway as reserve managers look to dive into more niche currencies to limit US dollar and euro exposure, but that is not an argument pointing to Aussie weakness.)
That presumption of current Aussie cheapness, which is also predicated on some China confidence, is pointing Lefeuvre even more strongly towards the other correlation break, Aussie/Gold and the S&P 500:
There is nothing more alluring than two assets that move together and show regular and short-lived correlation breaks. AUD/GOLD and the S&P 500 is such a pair, due to the near-perfect correlation between AUD/USD and the S&P 500.
Unfortunately, the last few months have disappointed, as the AUD/GOLD vs. SP 500 correlation showed a nasty downward trend – a decoupling clearly visible in the chart (right) below. This disconnect has also been visible in the SP 500 vs. UST 10-year yield, and the AUD/GOLD vs. 10-year yield.
He argues that if the Aussie/Gold pair starts to track the S&P 500 again, it will be an Aussie bullish story. Gold will suffer as risk kicks up and the Aussie dollar, high beta darling that is is, should benefit even more so than it will against the greenback. Of course, reversion speeds up for no man so don’t go betting your shirts; particularly if you are a China/ Oz bear.
One to keep an eye on we suppose…