The storm threatening currency markets may not be perfect, but it is well-developed – and the Australian dollar could be trapped in the middle, writes FIIG Securities’ Craig Swanger.
Volatile periods like the present can offer great opportunities for those looking to set or remove a long-term position, and for those already set, understanding the cause of such volatility and sticking to your plan is the most important thing to do. So what are the drivers for current market volatility?
The pound is now one of the most volatile currencies in the developed world, with volatility at its highest point since February 2009 when the post-GFC UK economy looked to be down and out. Whether they leave or not is unlikely to have significant long term impacts on the UK economy.
The oft-cited risk on exit is a fall in trade due to a weaker relationship with Europe; however, the EU has free trade agreements with several non-EU countries, including Switzerland, Norway and even Canada.
It’s unlikely that the EU would risk damaging its economy from less trade at a time when it cannot afford any new threats to its stability.
On the other hand, the worst thing that could happen for the UK economy is the vote itself, and the uncertainty that it has created as well as the impact deferred investment and hiring decisions are having on the economy.
The best thing that can happen for the UK is just to get past the referendum, set for 23 June, and allow certainty to return to the economy one way or the other.
In the longer term, there is a reasonable chance that Britain will actually be better off outside the EU, but the short-term transition to a new relationship with Europe will cause some pain, so on balance, there are economic and investment arguments for both sides.
Set a position on the pound based on the long-term strengths of the UK economy either way, but be aware that as the world gets used to an exited Britain, currency volatility will continue, so those looking to avoid the volatility should stay on the sidelines.
As long as the pound remains above 50p against the Australian dollar, it represents strong value in our view, but the Brexit impact has world markets polarised and volatility will continue.
A 'No' vote will see the end of volatility in July, while a 'Yes' vote will result in volatility for the remainder of 2016 at least.
The US election
The closer Donald Trump gets to seriously challenging Hillary Clinton, the more potential there is for volatility in equities and currency markets. This isn’t a political issue; it’s not about Republicans vs Democrats as much as it is about the polarising impact that Trump tends to have.
Markets don’t like uncertainty, and while much of Wall Street opposes Clinton’s stance on financial sector reforms, at least with her they feel that they know what they’ll get.
Trump on the other hand offers less certainty of what will actually happen, particularly with regards to foreign affairs, and the real economy will be impacted too as businesses choose to put off investment decisions pending the outcome.
The closer the odds of a Trump win, the greater the volatility. Look for opportunities to set long-term positions in the US dollar where the Australian/US dollar trades above our fair value range of 65-70 cents, but with the US election in November, there’s still a long way for this to play out.
US interest rates
The US Fed has stated that the timing of their next increase in rates will be “data dependent”, which typically means they are looking for economic data to show that the economy is continuing to improve.
At present, markets are pricing in one more increase in 2016, with the odds of a second increase rising and falling with the news cycle. There will likely be only one increase during the rest of 2016.
Most data in the past few months has been positive, without being exciting. Last week’s payroll data, a measure of the new jobs created in the economy in the month of May, showed the weakest growth rate in five years.
Markets reacted by selling the US dollar against most currencies and US yields fell to recent lows. Monthly economic data, particularly when so out of step with other indicators, should be watched with interest but do not make a trend.
To illustrate how volatility in one month’s data can be created, the US’s payroll data showed just 38,000 jobs created in May, down from 112,000 in April, but 35,000 workers were on strike at one company on the day of the survey. While this wouldn’t have made all of the difference, it goes a long way.
June’s payroll figures are likely to show a rebound, though there is one possible cause of a real fall in job growth: growing political uncertainty as Trump gets closer to the White House.
If hiring has slowed and June’s payroll figures are also low, US yields can be expected to fall again and the US dollar to be sold off.
June will be a big month for data, and if recent positive momentum continues yields and the US dollar will bounce back.
Fair value range on the 10-year US Treasury bond is 1.7 per cent per annum to 1.9 per cent per annum in our view.
It could be a long time before this plays out, probably as long as to the end of 2017, but the impact of the election on the real economy will be better understood as soon as June/July this year.
The Australian election
The Australian election is only really an issue for the Australian dollar, and relatively meaningless in terms of the differences between the parties, but should there be rising concerns about rising spending by either or both parties, currency traders will get nervous.
Australia’s prized AAA credit rating is a major driver of inbound investment flows and therefore the strength of the Australian dollar. Our fiscal outlook is weakening and the warnings from the credit ratings agencies and agencies such as the IMF have been getting louder – keep your deficits under control or risk losing your rating.
A change in the rhetoric by either party toward more spending, in order to buy the swing vote, will lead to more volatility.
The risk of spending promises rises as the election date approaches, particularly with a tight outcome expected, making the next four weeks the most volatile.
Weakening Australian inflation
The Australian GDP data last week was a classic tale of two economies: output is growing at an average pace, but Australians are getting paid less for that output, as shown by the national income figures. Wage growth is at its lowest point since the last recession Australia had in 1992.
Much like the US, while our headline employment figures tell a story of a strong economy, the headline is misleading and job growth has been zero since November last year.
Low wage growth and price pressure elsewhere in the economy suggest that the Reserve Bank of Australia needs to lower rates further to stimulate the economy and avoid the same disinflationary plague that has undermined business investment and credit growth.
Even the output growth in the GDP figures is misleading, as 1 per cent of the 1.1 per cent growth figure came from net exports, much of which was the increased output from mining operations established during the mining investment boom.
Exports, while a good look on paper, do nothing for supporting price growth in Australia and when the price received for those exports is falling, it also does nothing for the income of Australian companies and employees.
The RBA has reiterated its support of the 2-3 per cent inflation target, and while the incoming governor, Philip Lowe, may have a different attitude, he has also made it clear that if rates need to be reduced to achieve the inflation target, he will push them lower and keep them there.
The June quarter Consumer Price Index release will be very closely watched as it represents the likely deciding factor between further cuts in interest rates this year.
China has a slew of economic data coming out this week. Trade data is out on Wednesday and while the headline will likely read that their net surplus (export receipts over import costs) has grown, this hides the fact that their import prices, chiefly commodities, have fallen steeply.
Its export volumes, not value, will be more important in getting a picture of the long-term health of the economy.
Industrial inputs are expected to fall off sharply from the stimulus-fueled levels earlier in 2016, but consumer products are expected to remain strong.
Producer prices (PPI) data is released on Thursday, with an increase expected by markets, but the risks are to the downside in our view. A sharp decline in the PPI data will put negative pressure on the Australian dollar, as it implies lower demand likely for commodities.
On Sunday, Beijing releases its data for industrial production, retail sales and fixed asset (property, infrastructure and equipment) investment.
Expectations for industrial production and fixed asset investment are low already, but retail sales is an important release. The Australian economy is increasingly dependent upon consumer spending out of China, in particular education and tourism, so this is an important release for the outlook for Australia and could move the Australian dollar sharply one way or the other if out of line with expectations.
Data quality is the biggest issue for China and more reliable sources such as electricity production, freight movements and trade should be looked to instead. On the trade front, trade figures from Japan and South Korea provide a bleak view of the likely shape of the Chinese economy in Q2: Japan’s exports to China fell 7.6 per cent compared to the previous year, South Korea’s were down 6 per cent and Taiwan’s by 10.9 per cent.
China remains the largest risk to the Australian economy, and markets are very sensitive to this. A shock on any point of data will trigger a move in the Australian dollar.
The large volume of data this week means that volatility could be higher. Sensitivity to the Chinese economy will remain a feature of the Australian dollar for the foreseeable outlook.
Craig Swanger is a senior economist with FIIG Securities.
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