A concoction of negative seasonal trends, central bank currency jawboning and a global risk wobble could leave a sour taste for AUD, NZD and CAD in August
Small open economy central banks dealing with unwanted currency strength in different ways
Both the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ) have been quick out of the blocks to talk down their respective currencies, with concerns over the negative domestic macro implications met with some tentative - albeit non-credible - threats of FX intervention. Such rhetoric is understandable - and should have been largely expected - given that net speculative AUD and NZD longs were close to their five-year highs in late July. Unjustified currency strength - or one driven by a weaker USD and a "global risk bubble" - is like kryptonite for the Antipodean economies. On the flip side, we've heard nothing from the Bank of Canada (BoC) in response to the sharp CAD appreciation - it has seemingly shut up shop for the summer after hiking rates in July. We expect the BoC to play catch-up when it comes to taking heed of a strong currency - especially as the delayed disinflation and negative net export effects begin to manifest.
Structurally lower policy rates suggest limited scope for higher local yields
Updated central bank estimates of the neutral interest rate in Australia and New Zealand sparked some debate within markets over the past month. The RBA and RBNZ both now see the neutral nominal interest rate - the rate at which monetary policy is neither expansionary nor contractionary - at 3.5%. In Canada, the BoC sees the neutral nominal policy rate at 2.5-3.5%. While one can ineptly debate the timing of when these central banks will next hike, we prefer to take a step back and focus on the big picture: policy rates in these economies are set to remain structurally lower. If we take into account a significant degree of uncertainty around any neutral rate estimate, we could argue that the market implied policy rates of 2.5% (Australia), 3.25% (New Zealand) and 2.0% (Canada) in five years time aren't far off where they should be. Flatter rate curves rooted in markets, therefore, suggest little scope for monetary policy driven currency appreciation.
Tackling geopolitical risks
Rising geopolitical tensions present a new headwind for the traditionally risk-sensitive dollar bloc currencies. While Asian markets and economies are naturally in the spotlight given their proximity to North Korea, we believe it is too early to begin factoring in any negative economic shocks stemming from a regional flare-up. While the situation will require monitoring - especially for Australia and New Zealand - given their reliance on regional trade, the first-order effect may be an unwind of JPY-funded carry trades. In particular, we see the CAD at risk initially as rising geopolitical uncertainties sees the BoC hold pat on any further near-term tightening.
While one may assume that the quiet summer period is a good opportunity to pick up some yield, we note that August is typically a strong month for the US dollar against high-yielding risky currencies – namely the AUD and NZD, which have on average in the month of August depreciated by 1.4% and 2.1% respectively since 2010. It has been a strange environment to see markets relatively calm despite the world's two biggest central banks – the Fed and the ECB – both on the verge of making significant changes to their respective balance sheet policies. With global tightening around the corner, one would have expected the carry trade to come under some pressure. Maybe August is the month where the “penny will drop”. Equally, with central banks stepping up their customary jawboning attempts, downside risks remain for the dollar bloc currencies.