Australian Dollar Predicted to Weaken as Carry Trade Considerations Come to the Fore: HSBC

The Australian Dollar is likely to come under increased pressure as ‘Carry’ considerations eclipse all other factors in the currency’s valuation says foreign exchange analyst David Bloom at HSBC.

US interest rates are catching up with Australian rates as the Federal Reserve is expected to hike rates at least twice in 2017, taking them from their current 0.75 to 1.25%.

In Australia, meanwhile, a lower-than-expected inflation print has increased the possibility of the Reserve Bank of Australia reducing interest rates from the current 1.5 to 1.25%.

With the gap closing the Aussie will lose its shine as a preferred carry trade option in which investors make money from the interest rate differentials between two currencies – the lower rate one they borrow in and the higher rate one they purchase.

A carry trade sees an investor borrowing capital in a low interest rate jurisdiction and shipping it to a higher-yielding jurisdiction. Over recent years they have borrowed in USD and parked in AUD-denominated assets - something that has created huge demand for Australia's currency.

“For now we think as the Fed tightens policy, Australia’s carry buffer will erode, putting AUD-USD under downward pressure. For this reason we expect AUD to weaken from here,” says HSBC Bloom.

The Three ‘C’s: What Matters Now?

The Australian Dollar is typically driven by three main factors – Commodities, China’s Economy and the Carry Trading.

When all three are aligned the Aussie rises as happened in the great bull market of 2009-11, when AUD/USD rose from 0.65 to 1.10.

When all three are aligned negatively the Aussie weakens as happened in the bear market of 2013-16 when AUD/USD dropped from 1.05 to 0.70

Concerns at how a trade war between the US and China will harm the Aussie mean that the China ‘C’ is aligned negatively.

Rising commodity prices have not pushed up the Aussie but that ‘C’ is positively aligned.

The narrowing difference between Aussie and US interest rates means the Carry Trade is negatively aligned.

According to HSBC this third ‘C’ - or carry - is currently also the most significant.

Morgan Stanley Likewise Bearish

The weak Aussie inflation print has led strategists at Morgan Stanley to take a bearish view on AUD.

The negative call for the Aussie is corroborated by a poor outlook for the Chinese economy which they see “peaking”.

“With China's cyclical upswing approaching its peak, we think less support will come from a further terms of trade boost,” says Morgan Stanley’s Jesper Rooth.

The strategist goes on to extrapolate on the theme of stuttering Chinese growth:

“We are concerned on the rising risks to Chinese growth from onshore monetary policy tightening, and its potential spillover into commodities.

“The AUD TWI has risen in line with the recovery in RBA's commodity index since 2015, but we believe this support will weaken along with slowing demand from China.”

Rooth also notes how the poor Australian inflation result means “markets are likely to price out rate hikes in the front end,” corroborating with HSBC’s focus in the narrowing interest rate differential between Australia and the US.

However, Morgan Stanley go even further and also critique the Australian Housing Market.

“Our economists also look for a slowdown in Australia's housing market pushing RBA to deliver a rate cut in 3Q17,” said Rooth.

The strategist recommends shorting AUDUSD with a target of 0.69.