USD - FXA: Fade This AUD Play In The Face Of A Gloomy Near-Term Outlook

2023-05-18 11:14:30 ET

Summary

• The RBA’s surprise hawkishness this month may have boosted the AUD, but the near-term setup is far from compelling.
• The global commodity downcycle has shown no signs of slowing down, while China’s sluggish ex-services recovery offers little offset.
• With FXA’s interest income also well below the comparable risk-free rate, I am neutral on this FX play.

Going long the Australian Dollar ( AUD:USD ) hasn't been the blockbuster trade one would expect in a cyclical upswing for global commodities. A key reason has been that this time around, higher commodity prices have weighed on global growth. And unlike previous years, China hasn't come to the rescue either - the country's transition away from 'zero-COVID' policies hasn't yielded the non-services demand rebound many had hoped for. Outbound Chinese tourism has also been slow, as reflected in the slow recovery of Australia's services exports. So with the global economy set for another year of slower growth and falling commodity prices, the AUD should continue to be weighed down by deteriorating terms of trade.

The capital account could provide some respite, given the surprisingly hawkish turn by the RBA (i.e., the Australian central bank or 'Reserve Bank of Australia') at its policy meeting earlier this month. I wouldn't count on it, though, particularly with Australian markets already pricing in a June hike. For one, the RBA governors have expressed willingness to tolerate above-target inflation levels in the past. With global growth also slowing and most developed market central banks ending their tightening cycles this year, there is a significant probability that the next rate hike will get delayed post-June. With no clear catalyst on the horizon, the risk/reward on AUD plays like the Invesco CurrencyShares Australian Dollar Trust ( FXA ) doesn't seem particularly compelling relative to the low-single-digit risk-free rate.

Fund Overview - A Low-Cost Alternative for AUD Exposure

The US-listed Invesco CurrencyShares Australian Dollar Trust provides investors exposure to changes in the value of Australia's national currency, the AUD, as well as interest income via principal deposits held in an AUD-denominated, interest-bearing demand account (nominal rate of ~0.9%). The fund held ~$69m of assets at the time of writing and charged a 0.4% expense ratio (in line with other Invesco CurrencyShares funds), though the interest income has largely offset sponsor fees through the cycles. A summary of key facts about FXA is listed in the graphic below:

On a YTD basis, the fund has declined by 0.9% but has annualized at a 1.4% pace in market price and NAV terms since its inception in 2006. On a five- and ten-year basis, FXA returned an annualized -2.5% and -3.7%, respectively. By comparison, the benchmark WM/Reuters Australian Dollar Closing Spot Rate posted a -2.6% and -4.4% decline over a similar period, with the delta largely explained by the fund's interest income (net of expenses).

RBA Turns Hawkish Against All Expectations

The RBA had been in tightening mode for the better part of a year, but following the April pause, the central bank's hawkish turn at this month's policy meeting was a surprise. Supporting the case for a neutral stance was a weaker consumer inflation print, potential spillovers from the US/EU banking troubles, as well as commentary from the Governor indicating the RBA's willingness to tolerate inflation running slightly above target to ensure economic stability. The post-meeting statement showed the Governor's stance hasn't shifted, though, citing 'sticky' labor market pressures over the past month as a key contributor to the Board's latest interest rate increase. Thus, another cash rate increase is still very much on the table; the market seems to have agreed, pricing in a significant increase in the probability of a June hike.

With a more hawkish RBA now priced into the market, the risk/reward on going long the AUD is skewed in the wrong direction, in my view. As Q1 numbers showed , inflationary pressures are already decelerating, along with inflation expectations , so additional insurance against anchored expectations may not be necessary. Plus, the RBA has been willing to play 'catch-up' to other central banks on the monetary tightening path, so with job numbers worsening (employment down -4.3k in April; unemployment up 20bps), there is a good chance the RBA pushes back on a June hike. Beyond the latest labor force print, key data points to monitor include monthly inflation numbers and wage growth in the coming weeks; softer-than-expected numbers pose a downside risk to the AUD ahead of the June meeting.

No China Rescue Anytime Soon

Relative to expectations at the start of the year, China's recovery has disappointed on most counts. While services have been strong, Australia's exposure to the non-services part of Chinese demand (e.g., industrials and housing) means its exports have not benefited from any pick-up in demand thus far. The current account double whammy of declining exports and deteriorating terms of trade via lower commodities prices globally means the FX outlook is rather subdued. Those hoping for a respite from Chinese services demand will be disappointed as well - while a consumption-led rebound is playing out, outbound tourism has lagged the domestic recovery in China and remains well below pre-COVID levels.

Even in a best-case scenario where the post-reopening rebound broadens out and filters through to Australian exports, the country's energy transition plans, a key feature of the latest Budget announcement , will be a hurdle. Case in point - this year's Budget featured policies disincentivizing fossil fuel-related investments, from the extension of a A$12 gas price cap through 2025 to a higher 'Petroleum Resource Rent Tax' (i.e., a tax levied on gains from the sale of petroleum commodities). Expect further policy headwinds as global energy transition initiatives gain traction, driving an increasingly uncertain future for Australia's resource-heavy economy.

Conclusion

The cyclical reversal in commodity prices has driven the AUD lower over the last year, as reflected by the FXA's underperformance. While the China reopening had reignited investor optimism of an improved Australian current account, the ex-consumer/services data has been underwhelming, to say the least. Further weighing on the export outlook is the slow recovery in Chinese property starts, along with a slower-than-expected recovery in China-Australia tourism. Without a China offset and with the extended monetary tightening cycle also adding a significant growth constraint for global economies, the AUD could suffer from further terms of trade deterioration going forward.

The only respite has been from the RBA's surprisingly hawkish policy stance earlier this month - seemingly in contrast with the end of the tightening cycle for the other developed market central banks. Yet, the market has already priced in another rate hike at the June meeting, as reflected in the May rebound; thus, any delays vs. the June target could result in AUD downside ahead. Either way, the FXA's low-single-digit annualized return means investors would probably be better off expressing a long AUD view via Australian government bonds (ten-year currently yielding ~3.5%). In sum, I remain sidelined at these levels.

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