Aussie's weaknesses needed as it contributes significantly in rebalancing its economy

Recently the Australian central bank seems intent on shifting its policy stance from dovish to neutral based on recent meetings. In our point of view, we think that it is still premature at this moment to call the current easing cycle as over. We acknowledged positive developments such as the inflation and bank loans picking up. However, these improvements would only allow the RBA some break in order to evaluate the upcoming economic conditions. Two of the key risks are still in place:

1) Australia’s growth model shifted from mining to non-mining and resources’ sectors carries high uncertainties, and higher exchange rate may unwind previous efforts. The chart below shows Australia’s new capital expenditure volume Y/Y. It has been falling significantly since the beginning of 2012, reflecting the sluggish economic outlook among private sectors. Premature rate hikes only deteriorates business environment even further.

Australia’s new capital expenditure volume Y/Y (yellow) & China GDP Y/Y (white)

2) China’s slow down plus its less infrastructure activities reduced hard commodity demands from Australia. China Gross Domestic Product’s (GDP) growth is expected to slow down in the coming years. It highly correlated with Australia’s exports to China in the last decade.

Australia Exports to China YoY (yellow) vs. China GDP YoY (white)

The “punishment” for Aussie needs to arrive soon. Australia’s current account deficit is still much larger than New Zealand’s, as it prefers its currency to stay weak. We think Aussie is high due to the market moving ahead of China and Australia’s policy makers’ intentions. No evidences so far suggested the rate hike to be adjusted by the RBA, and the expectation of a large stimulus package from China in the coming quarters could just be a “wish”.

In the Options market, a 3-month risk reversal is reaching the 5-year peak level. Further numbers for “call options” added the needs for significant changes in Australia. It indicates that a downturn could be seen soon.

AUDUSD 3 - month risk reversal