CBA Global Markets Research
Politics and currencies: Importers beware?
An increasing AUD (and to a lesser extent NZD) and below average volatility is a positive environment for importers.
There are some external political developments over the horizon that may upset this positive combination.
Our near term tactical view is that AUD will head towards 0.9400. With AUD near the top end of its recent range, and volatility below the long run average, we think there is an opportunity for Australian importers to take advantage of optionality. While we are confident AUD can approach 0.94, it may not extend much further. We still think the medium term direction for AUD is down.
In the coming weeks, there are several overseas developments that could generate headwinds to AUD and lift implied volatility. Even without these developments, the fundamental backdrop still suggest AUD is ultimately heading lower (particularly in 2014) even though it is likely to head up to 0.94 in the near term.
US government budget issues
Acrimonious negotiations over US budget issues have pushed AUD and NZD down sharply, if temporarily, in the past. In August 2011, acrimonious negotiations over the debt ceiling encouraged Standard & Poors to downgrade the US government’s credit rating. AUD lost 4 US cents over several days (chart 1).
While not our ‘baseline’, there is a risk, albeit smaller than in the past, that upcoming US budget issues become disruptive. Should the US Congress fail to pass another ‘continuing resolution’ bill or fail to pass the latest US Federal Budget, non-essential areas of the US government could be shut down from 1 October 2013. We doubt a government shutdown will eventuate but we acknowledge it is a risk. Markets price in the probability of events occurring.
Further ahead, the US Government’s statutory borrowing limit (‘the debt ceiling’) is likely to become a market focus, particularly if the continuing resolution bill is difficult to secure. In early August, US Treasury Secretary Lew suggested the debt ceiling would be hit in mid-October. Although the surge in Federal Government receipts in 2013 has provided some breathing space, lifting the debt ceiling is necessary. We expect the US congress to lift the debt ceiling before the extraordinary measures are exhausted. However, should the negotiations be protracted, market nervousness may increase.
The prospect of military action against Syria has intermittently supported oil prices and the USD and the JPY given their safe haven status in recent weeks. In a televised address to the nation on 10 September (US time), President Obama suggested the chance of an imminent strike on Syria has receded. According to Obama the US ‘will work together in consultation with Russia and China at the UN Security Council’ via diplomatic channels to get Syria to ultimately destroy its chemical weapons ‘under international control’. Obama also indicated he asked the US Congress to postpone a vote on a possible military strike. That being said, Obama stressed the US military will keep the pressure on Syria and ‘will maintain readiness to strike’.
We interpret Obama’s comments as suggesting Syria has a limited (though undefined) window to comply. In our view, if Syria does not satisfy US (and others) demands to give up all chemical weapons soon, markets may begin to again price in military action. This may trigger a spike in implied volatility, a lift in the USD and the JPY and a fall in AUD and NZD.
German constitutional court ruling
Germany’s constitutional court is expected to make a decision whether the ECB’s outright monetary transactions (OMT) programme is compatible with Germany’s constitution following the German election (22 September). No exact date for the court’s ruling is known. The OMT allows the ECB to buy, without limit, government bonds with a maturity of 1-3 years of troubled Eurozone countries that subject themselves to the conditions of a European Stability Mechanism assistance program. The ECB has not used the OMT yet. However, the mere introduction of the OMT has in part been credited with introducing stability to European financial markets in the past year.
There are concerns Germany’s constitutional court may find the OMT is incompatible with Germany’s constitution. In addition, there are fears the German court constrains the ECB or Bundesbank’s actions in participating in the OMT. A major positive of the OMT is its perceived unlimited nature. Udo Di Fabio, a former judge on the court, has argued that the tribunal could even force the German government to unwind the EU treaties if it does not succeed in curbing the OMT programme. If one of these scenarios were to occur, Eurozone concerns would re-surface. In turn, implied volatility, the USD and JPY could lift while AUD, EUR and NZD could fall.
Implied volatility and currencies
Implied volatility is a measure of uncertainty. The greater the uncertainty, the higher implied volatility and the higher the cost of hedging currency risk.
When volatility is increasing, market participants typically seek the safety of US bonds and the USD; global growth is usually challenged and so commodity prices and the AUD also fall. There is also a ‘home bias’, whereby market participants repatriate capital when volatility is high. The home bias typically benefits currencies with large current account surpluses such as JPY and CHF.
Typically, there is a close inverse correlation between AUD (and NZD) and two commonly used measures of volatility: (i) 1 year AUD option volatility and (ii) the VIX (charts 4-6). When an adverse event occurs, such as the three possibilities described above, implied volatility rises and AUD and NZD falls. This is a double whammy for Australian and New Zealand based importers.