The USD is on fire at present, and even though the US economy is going to contract in Q1 and violently in Q2, the world’s insatiable desire to own USDs is not reflective of its view on economics.
No, the USD is a reflection of more subjective forces, such as the role the USD plays in the global economy, notably in cross-border lending.
Why the Love for the USD?
We should also consider that the world has built up a massive position in USD assets, notably US equities, and have been accumulating over the years with elevated currency hedges – that is, they switch their USD exposures (after purchasing the stock) into the domestic currency, such as the JPY for Japanese funds.
Hence, when the US equity markets have been smashed, we see hedge and pension funds having a large domestic FX exposure relative to the USD notional of the equity position. As a result, they need to periodically buy-back USDs to recalibrate. This is where we see the USD upside.
So, the logic goes, if US equities continue to trend lower, the USD, notably against the AUD, NOK, NZD, and GBP, will find further buyers and outperform.
Emerging Market Concerns Are Hurting the AUS
We also see that the one-way USD move is circling back into strong outflows from emerging market (EM) funds. With such large USD liabilities accumulated over the years, EM assets are getting smashed, as the notional US liability increases.
USD buyers also see limited risk the US Treasury department intervene, selling USDs in the market – so they have added conviction to add to long USD vs EM exposures even in this one-way appreciation.
Consider that in G10 FX, the AUD is the clear proxy of EM and when we consider spreads, funding and liquidity, it is a cheaper way to trade the EM pain trade.
Granted, we’re seeing solid flows to be short GBPUSD, but it’s the AUD/USD that is getting so much attention, with a tongue-in-cheek view on the desks that if you’re not short, you’re long… The moves are incredible.
Not just because AUD/USD has dropped from 0.6700 to 0.5600 (16%) in a matter of just nine days. But because the pair has taken out the 2008 GFC lows without any support at all.
The market is weighing up, not just the prospect of a tilt at 50c, but the all-time low of 0.4776 set in April 2001. The strength of the trend and the poor risk back-drop suggest these levels may occur sooner than we think.
Australian Domestic Factors
We can take domestic factors firstly and see the RBA has cut rates to 25bp, which was fully priced in and completely expected.
The RBA has also embarked on QE, buying government and semi-government bonds and targeting the 3-year government bond yield at 25bp, which is a form of Yield Curve Control (YCC).
They have brought home the idea of committing to keeping the cash rate unchanged for at least a few years, subsequently really strengthening forward guidance.
The bank has set up a Term Funding Facility (TFF), to offer three-year funding to Authorised Deposit-taking Institutions (ADI), with the idea of getting cheaper credit into the real economy (more on it here), which may help to compliment the next fiscal package due from the Morrison government this week.
All well and good, but it’s hard to be long AU assets when the country has yet to implement the containment measures that much of the world has already done. And it seems inevitable that they will.
The AUD as a Proxy of Global Growth
Despite actions from the RBA, the AUD is taking most of its variability from external factors.
We know the AUD is the proxy of global growth in GIO FX and right now we are staring at a contraction in Q1 and a brutal Q2. JP Morgan forecast US GDP contracting 14% in Q2, while Europe and the UK will contract 22% and 30% respectively.
Without trying to sound alarmist, that is going to feel like a depression, but this is what happens when you shut down cities, restrict movement, and close services.
The hope is that when the virus passes, activity resumes, the level of stimulus in the system should allow the economy to crank back up and we see strong re-hiring. This is the optimistic scenario.
The AUD is the prime vehicle for trading global economic contraction, and with EM right in the firing spot, the AUD is a pure momentum short here.
There are simply no buyers and liquidity is shot to pieces, so the sellers exasperate the downside move.
Until equities find a base and until volatility in markets settles, AUD/USD will be sold into any rallies and the momentum will see the pair heading towards 50c, even the all-time low.
EUR/AUD is another on the radar and has also gone on a tear of late and while incredibly extended, in these dynamics I like buying this into 1.9100.