Chart of the Week: Australian dollar set to rise?

Last year, we argued that Australia had several aces up its sleeve helping it to avoid recession despite the downturn in its largest trading partner — China. We were right. Now, China appears to be throwing in the towel on rebalancing and doubling down in a bid to kick-start growth.

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Last week, after keeping policy on hold for a year, the Reserve Bank of Australia (RBA) cut the cash rate by 25 basis points to an all-time low of 1.75%. That decision came less than a week after data revealed that consumer prices had fallen by 0.2% in the first quarter of 2016, marking the first quarterly decline since 2008.

In the statement released alongside the Bank’s interest rate cut, Governor Glenn Stevens observed that “commodity prices have firmed noticeably from recent lows.” In our view, that turnaround over the past month or two is consistent with some recovery in economic activity in China as it reverts to its old growth model of credit-fuelled investment.

Closely correlated with industrial commodities prices, the Australian dollar has also strengthened since its recent trough in January — up 3.9% on a trade-weighted basis at the time of writing. Although this complicates Australia’s transition from its mining investment boom to broader-based growth, we believe that the RBA should refrain from further interest rate cuts. Whether it will or not is finely balanced.

Nevertheless, we would recommend going long the Australian dollar against the New Zealand dollar. That is because the former is likely to experience greater upward pressure as China reverts to its old growth model. In other words, the prices of Australia’s metal-based commodities are likely to rise faster than New Zealand’s agricultural exports as China reverts to its old ways, with growth driven by investment rather than consumption.

Our chart uses the copper to milk price ratio as a timely proxy for this, with copper and milk some of the most important exports for Australia and New Zealand, respectively. As our chart highlights, the copper to milk price ratio has been on an upward trajectory since January, offering further evidence of a doubling down in China that is likely to support the Australian dollar.