Thursday, July 23, 2015

Shorting AUD/USD: on FDI and Reflexive Potential

Summary Reasons for Shorting AUD/USD

  • Technical downtrend is intact
  • Demand of AUD will be weaker in the future due to lower FDI and portfolio flows. Trade balance is negative but that’s a less important factor in my mind.
  • Factors that make AUD’s “reflexive” – price movement here can be self-reinforcing, rather than self-correcting 
Shorting AUD/USD is a fairly popular trade. Here are what I gather as the most cited rationales for shorting AUD/USD. Australia's main exports are iron ore and coal but prices for which have fallen and will likely stay low due to weak demand from China. Trade balance will deteriorate. The Reserve Bank of Australia thinks further depreciation is necessary and will keep rates low or even cut rates to stimulate the economy.

I agree with that line of reasoning, but trade balance and lower interest rates are not the only reasons that AUD will continue to depreciate. Going forward, in my opinion, foreign direct investment and potential for “reflexivity” will be bigger drivers of AUD decline.

Importance of Foreign Direct Investment

In the chart below, I used balance of payments (BOP) from 2006 to 2014 as proxy for historical inflows and outflows. Australia has persistently ran trade deficits and even bigger primary income deficits. What propped up demand for AUD in the past few years were foreign direct investments (FDI) and sometimes portfolio flows.

Australia balance of payment - FDI is key

Note how trade balance is a relatively minor contributor versus other flows. Primary income is mostly stable while portfolio investment is fickle (and likely negative going forward). FDI though, has been consistently strong, but will likely deteriorate drastically going forward.

FDI is concentrated in the mining sector (~roughly 40% of foreign investment in Australia), and that is likely to drop off given prevailing weakness in commodity prices. Demand from China will stay weak given its continued shift away from an investment driven economy.

Reflexivity - Quick Background

But how much of that is already priced in? That’s always tough to know. A different question though, is will lower exchange rates hurt economic fundamentals and lead to even lower prices? i.e. is there a reflexive relationship here? I think so, but first a quick summary of George Soros’ reflexivity framework (as it relates to currencies) is as follows:  
  • Prices are driven by different factors of supply and demand. Some of these factors are self correcting, and some are self-reinforcing. 
  • Self-correcting means weaker prices -> improving demand vs supply -> stabilization in prices. 
  • Self-reinforcing means weaker prices -> deteriorating demand vs supply -> further weakening in prices. 
  • To see if a trend will continue, an analyst can break down price into different sources of supply/demand, and determine if self-reinforcing flows outweigh the self-correcting ones. 
In the context of foreign exchange:
  • Price = nominal exchange rates. Supply and demand are inflows and outflows in the balance of payments items. 
  • Trade balance is typically a self-correcting: lower nominal currency -> lower real currency -> better trade competitiveness and trade balance -> stabilization of currency 
  • Portfolio investments tend to be self -reinforcing: lower nominal currency -> expectation of even lower FX -> expected currency losses tend to outweigh interest rate differentials for bonds and detract from equities returns). 
  • FDI could be either self-correcting or self-reinforcing 


With that background, here’s why I think AUD/USD will be a reflexive situation that keeps driving downward.

1. The main self-correcting flow, trade balance, is a relatively minor factor here (as shown in the BOP chart above). Further, Australia’s trade balance will likely see less improvement from currency devaluation due to its unique situation. Lower prices of main exports (iron ore and coal) is not going to help much if the problem is structurally lower demand from your customer in the first place. Australia’s main competitor in iron ore is Brazil and that currency is even weaker. So Australia is not going to get much of a boost in trade balance from weaker AUD.

2. FDI is likely a self-reinforcing flow in this case – weaker AUD will lead to weaker FDI. Remember again, FDI for Australia is big in the mining sector. With commodities, prices are in USD but local production costs are in the local currencies. When Australia and Brazil’s currency weaken versus the USD, local costs are effectively lowered and that will pass through to lower commodity prices. Would you invest in a mining project when 1) commodity prices will likely stay low or get even worse, and 2) the sector already has excess capacity? I don’t think so.

3. Portfolio inflows are self-reinforcing. For Australia, portfolio flows are mostly debt securities as opposed to equity. 10 year government bonds for Australia yield ~2.85% versus ~2.25% in the United States. What little extra yield you get from investing in an Australian bond could easily be overwhelmed by movements in currencies, which is decidedly negative in this case.

My conclusion is that the downward move in AUD/USD will continue, because the self-reinforcing elements (FDI and portfolio outflows) outweighs the self-correcting mechanism of trade balance.

This may take a while to play out though, and you incur negative carry on the trade. So timing and technicals do matter. AUD/USD hovers around 0.74 at the time of this writing. I am short and have a stop loss around 0.77 and my eventual target is as low as 0.65. The risk is if Australia comes out with massive investment project (develop North Australia for example) and attracts money from abroad. But that is unlikely in the current government and in any case unlikely to offset weakness in mining projects.

Sunday, July 5, 2015

What Drives NZD/USD

In my last post I mentioned shorting the NZD/USD. At the time of that trade, I only had a rough sketch of the thesis: 1) the chart already showed a breakout to the downside, and I was waiting for a retouch to confirm the resistance level around 0.71, 2) I happened to be looking into Fonterra and had developed a negative view, but I thought NZD/USD might be a better way to implement that short. 3) a quick calculation of fair value based on BIS Narrow REER showed me that NZD could go as low as 0.60, thus a highly favorable risk and reward.

Then Reserve Bank of New Zealand announced a (surprise) rate cut on 6/11/2015 and NZD collapsed below 0.71. New Zealand is now lowering rates while US is raising rates. I also got my technical confirms and went ahead with the short. During the past 2 weeks that trade works really well - the NZD has went down so fast that I’m now reassessing the situation and bracing for a pullback (but staying short).

It was a bit of an “invest first, investigate later” type of situation, and I wanted to catchup in terms of understanding what drives NZD/USD over the long run. So I plotted the chart below with 1) NZD/USD, 2) the Dollar Index (DXY), and 3) NZD real effective exchange rate.

The cool thing about currencies is that they do move in long, multi-year trends. In the next section, I listed out the major up and downs over the past 2 decades and did some research to explain the drivers. The short-one sentence summary would be this: the drivers of NZD/USD are USD strength, NZ’s growth differential vs rest of the world, interest rate differentials, and commodity prices/terms of trade. I'd put inflation differentials up there too but that has a more indirect effect as it really drives the market through interest rate policies.

What Drives NZD/USD through the decades

Summary of various NZD/USD trends

  • 1988 (not shown on chart) 
    • NZD collapsed from ~0.7 to ~0.55. NZ had stagnant growth and bursting of a commercial property bubble.
  • Late 1996 – late 2000 – Big downtrend from 0.7 to 0.4
    • USD was on a strong uptrend. US went through an investment boom and productivity spike which drove up USD’s real equilibrium exchange rate (think of a 2 dimensional plane with a) upward sloping savings – investment and  b) a downward sloping current account balance on the X-axis and real exchange rate on the Y-axis. The S-I curve is upward sloping while the current account balance curve is downward sloping. Here the USA have more investment, so the Savings - Investment curve would shift to the left, leading to higher real exchange rate)
    • On the NZ side, in 1997 the economy fell into recession with after 2 summers of drought. NZ was also hit by the Asian financial Crisis.
  •  2002-2005 – big uptrend. From ~.40 to .~74
    • General weakness in USD. USD was overvalued at its previous peak, but the structural factors that boosted USD were now reversing. The downward move coincided with bursting of the dot com bubble, and the subsequent low US interest rates. 
    • NZ has positive growth differential versus rest of world. NZ had a positive output gap and positive short term interest rate differential. Commodity prices were strong.
  • 2005-2006- dip from ~.74 to ~.60 then a rebound
    • The market believed that New Zealand was falling into recession, and GDP contracted slightly in December 2015. But this turns out to be a false alarm and GDP reaccelerated in 2006, and NZD/USD went on a strong rebound from 2006 to mid-2008 (~0.6 to >0.8)
  • 2008/2009 - a massive dip during the Great Financial Crisis. There was another dip in 2011 when NZD fell from 0.88 to 0.74 due to prospect of Eurozone breakup.
  • June 2011 – 1H2014: NZD/USD traded with general uptrend rising toward 0.89 
    • Context for 1H14. NZD benefited from diverging monetary policy versus the rest of the world. The market had gotten used to QE with US, Eurozone, Japan all in monetary easing mode. But in 1H14 the RBNZ actually hiked rates. NZD benefited from strong interest rate differentials (both spot and expectations). Meanwhile Fonterra and the dairy sector enjoyed historically high prices, so the country enjoyed strong terms of trade which propped up the NZD.
  • 2H14 to current.. big downtrend from 0.89 to 0.67
    • US Dollar Index went on a big spike. 
    • On NZ side, growth slowed and market had developed expectation of continued rate hikes which was not met. Dairy prices and commodity prices have collapsed. RBNZ came out with aggressive stance saying NZD is over-valued and actually intervenes to depreciate NZD. 
    • By June 2015 RBNZ cut the Official Cash Rate and set expectations for further rate cuts. NZD/USD dropped below a critical support level.