Friday 20 February 2015

Why I am short AUDJPY

On the folly of making market calls

I am generally of the belief that publicly making predictions about the market opens one up to ridicule when you are wrong and has not got that much upside. And rightly so, as the implicit assumption is that you are right and everyone else in the whole market is wrong. This is a pretty arrogant assumption.

Having said that, please treat this as a discussion piece to which I am very open to hearing opposing views. It goes without saying that this is not a recommendation to trade - just an explanation of my position.

Also, please note that Dacharan specialises in systematic repeatable strategies. This idea, due to the lack of large quantities of inflation linked bond data, is not fully tested. As such this is a personally held position.

Fair Value Model

In the course of my time in the markets, I have developed what I call a fair value model for currencies. It assumes purchasing power parity but adjusted for real yields. I have found it to be generally reasonably highly correlated with actual exchange rates. I base the numerical part of my analysis on this.

The graph below shows the evolution of the fair value of Australian Dollar against Japanese Yen (AUDJPY) over time, compared to the move in the actual exchange rate. As can be seen, they are not entirely unrelated. Over the past year, you can see on the graph that the 'fair value' of the exchange rate declines considerably. This is due largely to Australian interest rates declining, by 1.5-2% on the 10 year bonds. Instead of a fall in the exchange rate, we have actually seen a rise.

The current fair value, according to my model, is around 71. This contrasts to the 93 level it is currently trading at.

The AUDUSD rate has fallen commensurately in this time period and so we could really call this an unreasonable rise of USD against JPY. This would be fair; according to my model USDJPY fair value is around 100. However, there are good reasons to beware a dollar short in the current environment, and I don't think there are many to beware an Australian dollar short.

To put it simply, I think that Yen is the most undervalued currency in the developed world and that is why I have chosen it for my long. The reasons for AUD as the short are below.

China Rebalancing

As Michael Pettis convincingly argues, China's economy must very quickly start rebalancing from investment to consumption if it is to avoid a crash. China's policy makers appear to be aware of this and I think that the heavy industrialisation must continue to slow down. They are not in position to do another stimulus as they were in 2008 and the previous investments can only make a return if there is consumer spending. Commodity supply has increased due to the past Chinese demand, and when demand falls the prices must follow. To some extent this is already happening, but I can not see anything to significantly reverse this and it may well get worse.

Australian Imbalances

I would say that it is extremely unlikely that Australia can have avoided Dutch Disease in the period of high commodity prices. The Australian economy has been extremely reliant for exports on commodities. Australia has persistently been running large current account deficits of 3-4% of GDP, and I imagine that the parking of Chinese savings in the Australian economy has been a reasonable constituent of this. This means that at the same time as a large windfall of foreign cash was coming in, gross borrowing was also going up. Net debt to foreign creditors had risen to 55% of GDP in 2013, and is getting higher.

Where does this extra money go? Unless there are productive investment opportunities that would not otherwise have been funded, the influx of foreign savings as well as commodity boom almost certainly will lead to a property boom/ bubble, and, although I am not an expert on the Australian property market, this appears to have been borne out in reality.

In short, the end of the commodity boom has got to have placed Australia in a precarious position. In order to keep demand up at previous levels, debt will have to increase greatly. The other option is an Australian recession.

But more generally, with the reduction of commodity exports, and the already high trade deficit something will have to give in order for the economy to rebalance. And really this has to be the exchange rate. I do not know when this will come, but feel that it must do so eventually.

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