How Will the Aussie and the Kiwi be affected by ‘Slowing’ Chinese Growth?

This post will discuss Chinese growth, the recent decline in base metals’ prices, and the outlook for the Australian and New Zealand Dollars.

The story of China’s “hard landing” is an easy sell: excess liquidity in the Chinese financial system, thanks to the People Bank of China’s massive expansionary monetary policy over the past few years, will stoke inflation; and then the PBoC will be forced to tighten policy too quickly, ensuring what is known as a liquidity trap, choking off growth far too rapidly.

But the naysayers have been proven wrong thus far. The 4Q’12 annualized Chinese GDP figure came in at +7.9% from 7.6% in the 3Q’12, and growth is expected to have a floor near +7.5%, according to estimates provided to Bloomberg News back in December. As always, we look to the PMI Manufacturing index, as well as base metals’ prices (the literal building blocks of society come from base metals), as forward indicator of Chinese growth prospects. The signs aren’t welcoming going forward.

Chinese PMI-manufacturing and iron ore spot

Iron Ore is a strong indicator of future growth prospects because it is required in the process to make steel; and steel, of course, is the preferred material to construct larger buildings, making it a popular resource in emerging market economies like China. Over the past several months, Iron Ore prices rallied quickly; but in February, prices have started to pull back as the Chinese PMI Manufacturing index has eased. Not only does this mean China could see slower growth going into mid-2013, but so too could Australia and New Zealand, as two regional economies for which China is their number one trading partner.

AUDUSD v RBA   NZDUSD v RBNZ

On their own, Australia and New Zealand are very different economies and countries. But in the broad context of global finance, their currencies are very alike – both are considered to be high beta commodity currencies, given the higher interest rates offered by their respective central banks. Considering where the market is pricing in rate expectations for the Australian Dollar over the next 12-months, it appears that the Australian Dollar is below fair value; on the other hand, the New Zealand Dollar is trading slightly rich relative to its interest rate expectations.

In the context of Chinese growth, Australia is more likely to be directly affected than New Zealand, so Iron Ore, Australia’s top export, serves as a strong proxy for growth hopes for China. At this point in time, given the signal in not just Iron Ore, but Copper as well (which has fallen back very sharply the past several weeks), it appears that the Australian and New Zealand Dollars could be poised for continued weakness throughout the 1H’13, before turning around and strengthening in the 2H’13, especially against the European currencies. The AUDUSD could decline into 0.9800 before rebounding back towards 1.0600, while the NZDUSD could fall towards 0.8000 before a move back to recent highs near 0.8500.

Regional Politics in Europe Awakes a Sleeping Giant

This post will discuss how revived regional political tensions have provoked the reemergence of the sovereign debt crisis, accelerating the timeline for significant Euro weakness from the 2H’13 into the end of the 1Q’13. We also explain why any calmness in markets will be as a result of the European Central Bank, and nothing more.

As we said in the first post in this series, coming into 2013, peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency into February 1. But the journey from $1.2041 versus the U.S. Dollar on July 24 to $1.3710 on February 1 was not an easy one; at many points it appeared like the European Central Bank-induced rally was going to fall apart. This go-around, it may be time.

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With each tumble in the EURUSD in 4Q’12, there was an ensuing rally. But why not; the Federal Reserve had begun its QE3 program and the political situations from Greece to Spain were much calmer than they had been back in July. Yet everyone was very aware that the economics of the region (discussed last post) were remaining quite sour and in most cases, getting worse. Clearly, just as was the case with the rally in the S&P 500, there are other forces in play here driving confidence in the Euro, because a regional growth rate at its weakest point in the past five years is no reason to be bullish.

EUR/USD Spot

In order to buy governments time and bring down sovereign borrowing costs, ECB President Mario Draghi fulfilled his late-July pledge to do “whatever it takes” to save the Euro by pledging a liquidity program known as the OMTs, or Outright Monetary Transactions, which would effectively place a ceiling over Italian and Spanish yields for an unlimited amount of time, so long as budget consolidation was taking place.

Initially, similar to the impact that the Federal Reserve’s QE has had on the U.S. Dollar, the expanding ECB balance sheet size in early-2012 led to a sharp depreciation in the value of the Euro. But with bond yields tethered down and no additional liquidity injections required, the ECB was able to reverse the its balance sheet expansion by late-2012, and reduce its size in the beginning of 2013. While this initially led Euro strength over the past several months, sufficient evidence has gathered that the crisis may have been stirred.

The Italian elections that took place at the end of February emphasized how fragile the overall situation is in Europe: voters are becoming angry with their leaders, feeling as if supranational or even international powers are dictating policy. This is fitting, given the governments present in Greece, [especially] Italy, and Spain presently. Pandora’s Box has now been opened: 55% of the Italian electorate voted for the anti-austerity candidates, meaning that the Italian economic picture could worsen dramatically quickly once more, if investors lose faith in the bond market.

Greece and Spain are no “picnics” either. The Greek government remains highly unpopular and will likely head back to elections once German Chancellor Angela Merkel retains her chancellorship in the September German elections, while the Spanish government faces corruption charges and still puts off the necessary budget reforms desired by the core Euro-zone countries. We find there little reason to be bullish on the Euro, given the significant backdrop of European growth and political concerns, and wouldn’t be surprised in the slightest to see the EURUSD trade under 1.3000 for a sustained time (>3 months) in 2013.

This series of eight posts will focus on the major themes affecting currency markets. The eighth and last post in this series will review Chinese growth, performance of base metals, and forecasts for the Australian and New Zealand Dollars for 2013.

European Growth Contracts to the Depths of the Financial Crisis

This post will discuss the weak economic conditions that have started to proliferate in the Euro-zone once again, marked by declining rates of production, consumption, inflation, and overall growth, all of which are exacerbated by a recently-strong Euro.

There was a period in mid-to-late-2012 when the financial aspect of the Euro-zone sovereign debt crisis appeared to be easing and the ailing economy appeared to be improving. To start, both Italian and Spanish sovereign bond yields compressed rapidly, to much narrower levels relative to their German counterparts. Then, as a sign of confidence in the region, the Euro rallied swiftly, especially against the Japanese Yen and the U.S. Dollar, culminating in a rally into $1.3710 on February 1, from $1.2041 on July 24. Conditions appeared to be improving.

Euro-zone GDP

But, as the saying goes, “don’t judge a book by its cover.” The period of calm that enveloped the Euro-zone over the past half-year warranted a second review, and as 4Q’12 GDP figures have showed, the broader region is now embroiled back in a recession equivalent to the deepest depths of the 2008 to 2009 global financial crisis.

Speaking from the point of having a budget surplus, Germany among other core Euro-zone countries have insisted that leaders in heavily indebted periphery countries embark on acute austerity programs, intended to correct any budget imbalances with a very heavy, swift hand over the next few years. The ramifications have been dramatic: record high unemployment rates in Italy, Greece, and Spain; substantial unpopularity among French, Italian, Greek, and Spanish politicians; social unrest across the continent; and relevant questions over the viability of the European Union as a whole in the long-term.

Now that austerity is creeping into the core of the region and growth begins to slow, we turn our attention to the Purchasing Managers’ Index readings from the major Euro-zone countries, to effectively gauge where growth is heading in the 2H’13. It’s evident here as well that growth rates should continue to contract, and that the crisis is going to get worse before it gets better, if anything.

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With all of the major PMI readings (except for Germany) at or below the growth level of 50.0 (the further away from the 50.0 line, the stronger the condition; above 50.0 is growth, below 50.0 is contraction), businesses are signaling continued weak conditions that are likely to persist for the foreseeable future. Seemingly, over the past two months, the region’s fundamentals have gotten worse, as any recovery on the horizon has been wiped out amid a sharp turn lower in sentiment, led by a very weak French PMI Services reading. When the weak growth situation is considering in context of the burgeoning political problems again, it’s clear that the Euro will struggle this year as markets turn to the European Central Bank for help. The EURUSD could slip below 1.3000 in the 1Q’13, but ultimately should finish the year in the 1.2500 to 1.2750 range.

This series of eight posts will focus on the major themes affecting currency markets. The seventh post in this series will discuss how the political situation in Europe is pushing the monetary union back to the brink.