Reality check on CAD and AUD assumptions

Jeremy Stretch, head of FX strategy at CIBC in London, asks whether the Canadian or the Australian dollar is a better buy in an environment in which both appear attractive alternatives to struggling traditional currencies

The global economy is potentially set for a comparatively supportive growth environment on an aggregate basis.  The CIBC economics department is looking for global growth to average around 4% over the next two years, though that remains some way short of the 5% annual expansion in the four years before the recession.

But, at a micro level, huge risk uncertainties abound. On that basis, we would ask whether the market has become too complacent regarding the risk environment. This is especially the case as we move towards the end of cheap US funding under the second round of quantitative easing, dubbed QE2, which has fuelled the rampant jump in equity and commodity prices.

Our internal risk model, which uses foreign exchange and equity volatilities alongside corporate and swap spreads, rose to record highs ahead of last week’s surprise move by Standard & Poor’s to place the US on a negative ratings outlook. The growth in risk appetite has come about despite the combination of a two-speed European economy facing increasing structural concerns and rising rates, emerging Asian economies importing US monetary policy and facing rising inflationary pressures, a Japanese economy attempting to deal with the aftermath of the earthquake, and the belated recognition of the implications of a looming US fiscal crisis.

The currencies most closely correlated with risk sentiment or equity performance, such as the euro, Australian dollar, Canadian dollar and Mexican peso, have all seen investors move towards sizeable long positions, with the Australian dollar and Mexican peso reaching all-time highs in the past two weeks.

The most recent FX reserves data from the International Monetary Fund revealed little change in the proportion of US dollar-denominated reserves – it remained essentially static at 61.4% of total allocated reserves at the end of 2010. But the rapid acceleration in nominal reserves (up more than 13% in 2010), and the news Chinese reserves exceeded $3 trillion by the end of March, underline increasing demand by reserve managers to find alternative outlets for their funds.

According to survey evidence provided this month by Central Banking Publications, both the Australian dollar and Canadian dollar have proved net beneficiaries of reserve diversification. These flows are likely to continue until reserve accumulation slows through either a rapid deceleration in growth or a move away from the importation of US monetary policy through fixed exchange rate regimes.

While we have seen reserve managers attracted to the strong macro and fiscal environments of the Australian dollar and Canadian dollar, the risk and commodities correlations are noteworthy. For example, AUD/USD has a correlation coefficient of 0.91 with the CRB commodities index over a two-year horizon, and one of 0.95 with the US S&P index over the same period.

While purchasing-power parity (PPP) estimates have little predictive value, the OECD estimates the Australian dollar is overvalued by almost 38%. So record long positions underline the currency is increasingly over-bought and vulnerable to a correction; this is especially true in the context of expectations China will continue to tighten monetary policy to fight inflationary pressures.

The Canadian dollar is susceptible to similar commodity and risk dynamics to the Australian dollar. While Canada might be the only G-7 member to have net commodity inflows, one should not overplay the influence of factors such as oil. The five-year inverse correlation coefficient between the Canadian dollar and WTI crude prices is –0.43. But the Bank of Canada’s monetary policy report for April revealed 18 of the 23 components within the Bank’s commodities index are trading beyond their real long-term averages, implying the influence of elevated commodity prices on the currency cannot be ignored.

In the event of a deceleration in Chinese demand as monetary policy and reserve requirements continue to be tightened, we would look for a larger effect on Australia than Canada. Furthermore, the spike in Canadian inflationary pressures in March places additional pressure on the Bank of Canada to tighten its policy, even though the Canadian dollar remains elevated. In PPP terms, the OECD’s estimation of the overvaluation of the Canadian dollar is around half that of the Australian dollar.

While we have Australian dollar speculative positioning at record highs, the Reserve Bank of Australia seems content with its policy stance, in contrast to Canadian policy. The Canadian output gap is expected to close in a little over 12 months, while Canadian consumer prices increased at the fastest pace in 20 years in March, leaving headline CPI inflation outside the target band at 30-month highs.

So while the Australian dollar and the Canadian dollar might both be susceptible to deleveraging if risk dynamics become more reflective of broad underlying dynamics, the over-bought and over-extended Australian dollar looks increasingly vulnerable compared with its Canadian cousin.

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