As oil fell for six straight months in the second half of 2014, plunging 47% to post its biggest decline since the 2008-09 crisis, the reaction in energy-dependent currencies has yet to unravel. The worst performing currencies so far have been the Russian ruble, down 43%, followed by the Norwegian krone and Mexican peso at -16% and -12% respectively. The carnage in energy commodities and sell-off in metals were largely to blame. But for those who regularly trade G20 currencies, the duel remains between the Australian and Canadian dollar, both of which have dropped 8% against their U.S. namesake. So which commodity currency will get the upper hand in 2015?
The Aussie outperformed the loonie from the first trading day of 2014 due to robust Aussie fundamentals: higher yields, less exposure to weak U.S. growth in Q1 and more helpful exposure to China. But that all changed in September when the Aussie could no longer ignore aggressive jawboning from the Reserve Bank of Australia, deteriorating fundamentals from China (shenanigans in credit markets and accelerating declines in metals) and improving dynamics in Canada and the United States. Once the Aussie’s decline caught “down” with the loonie, the two currencies’ performance matched each others.
The contrasting yield differential picture between Australia and Canada is weighing on the Aussie rather fast. Between December 2013 and December 2014, the differential of Australia’s two-year sovereign bond yields over that of Canada fell from 3.34% to 1.93%. The 10-year yield differential fell from 1.78% to 1.14% over the same period. While the move may seem excessive and overplayed, Aussie yields could deteriorate further on potential RBA action later in the year.
The RBA is increasingly expected to cut interest rates in 2015, compared to the Bank of Canada, whose negative oil factor will remove 0.20% to 0.30% of GDP, but may not go as far as obliging the Bank of Canada to slash rates. The Aussie’s woes are mainly highlighted by the 50% plunge in the price of iron ore, which accounts for 20% of Australia’s export revenues.
Aside from other AUD-negative factors such as Aussie consumer confidence hitting three-year lows and RBA governor Glenn Stevens aggressively talking down his own currency, the elephant in the Australia economy is China, which buys 35% of Australia’s physical exports. These are led by iron ore, followed by coal. China had 42 consecutive months of negative produce price deflation, while consumer inflation hit a fresh five-year low. Prolonged manufacturing overcapacity and price cutting pressure on retailers are to blame. Once corporate China starts to feel the bite of eroding profit margins, job growth will further slow and weigh on the all-important household income growth. Meanwhile, China’s real estate prices trended downward in early Q4 2014, posting the first decline in three years.
In Canada, mining and energy account for a third of exports, half that of Australia’s exposure to the ailing sector. Unlike Australia’s exposure to the slowing Chinese economy, Canada’s exposure to the growing U.S. economy is positive, especially with a falling loonie and strengthening greenback. Canada has long been watched by hedge funds as the next country to sustain a housing downturn considering that home prices are valued by as much as 10%. But Canada’s dollar defied these worries as the Bank of Canada remains the only G8 central bank to not descend into quantitative easing, leaving its overnight rate at 1.0%, higher above the rest, and unchanged for a record 65 years.
The erosion in oil prices will undoubtedly impact Canada’s oil revenues, but tightening labor markets and better readiness to adapt to the slowdown in mining and gas than Australia shall continue to reward its improved yield differential with the land from down under. While AUD/CAD is expected to lose further ground towards 90¢, a more attractive Aussie play is targeting 78¢ against USD and 1.56 against the euro. USD/CAD is already nearing a popular target of 1.17, but a less obvious play is shorting CAD/CHF, targeting 0.78 as the Swiss National Bank struggles to weaken its currency.
Ashraf Laidi is Chief Global Strategist at FX Solutions/City Index, founder of AshrafLaidi.com and author of “Currency Trading & Intermarket Analysis”.