News that the IMF has concluded that the Australian dollar is about 10% overvalued and that is accommodative monetary policy was seized upon as an excuse to extend the Aussie’s losses to new lows for the day, near $0.9365. However, there is really no news content there and bid were seen ahead of yesterday’s low near $0.9355.
The IMF estimate of fair value is quite conservative. For example, the by the OECD’s estimate, the Australian dollar is a little more than 27% overvalued. Using consumer and producer prices to calculate purchasing power parity would put the Australian dollar 27% and 22% overvalued respectively.
The IMF reached its decision following Article IV consultation with the government, central bank, regulators, business and labor leaders. It is probably a more accurate reflection of the domestic perception of the overshoot than the economic models.
Recall that purchasing power is the level that currencies are expected to gravitate around in the long-run. By definition, it will also gravitate around a long-term moving average. The 10-year moving average, for example, comes in near $0.8700. It has risen by about 3 cents since the end of last year and is still rising gently (about 1/5 a cent a month). This back-of-the-envelop method would estimate the Aussie overshoot is closer to the IMF’s assessment.
The IMF also endorsed the current monetary stance. The IMF’s mission head said there was scope for further RBA easing if the growth outlook worsened. The implied rates in the forward market suggests no additional easing is anticipated. However, the OIS term structure suggests about a 1 in 4 chance of a rate cut by early Q2.
The big structural trade we had recommended at the end of last year was to short the Aussie against Mexico. While the Aussie was among the most overvalued currencies (by the OECD’s measure), the Mexican peso was among the most undervalued. We also had anticipated a moderation of China’s growth and commodity prices, for which the Aussie is a liquid and accessible proxy. We also suggested Mexico is partly a proxy for North America and the shifting competitiveness (Mexico’s unit labor costs fell below China’s, according to the Boston Consulting Group).
The Aussie lost a bit more than 17% against the peso through August. It has recovered by about 12% over the last few months, partly helped by soft Mexican fundamental data and slowness in implementing structural reforms and partly, the Aussie has been helped by the stabilization of the Chinese economy. However, the correction appears over, with the Aussie’s decline ready to resume. A break of the MXN12.00 would lend greater credence to this bearish view.
The Australian dollar itself is also looking heavier after correcting higher over the past week. The Aussie’s three-month bounce (Aug-Oct) ran out of steam after correcting about 50% of the year’s decline (~$0.9760 in late Oct). As it has worked its way lower, the 20-day moving average is succeeded in turning back counter-trend advance. It is found near $0.9445 presently. A break of $0.9350 support could spur another cent move and that is where the important technical test will take place (~$0.9250-60).
This piece is cross-posted from Marc to Market with permission.