G10 Focus Why the market underestimates risk for AUDUSD 1.

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Todd Elmer +65 6657 2932 todd.elmer@citi.com Steve Englander +1 212 723 3211 steven.englander@citi.com ! AUD draw-downs are more often a function of swings in global risk sentiment and asset prices than they are domestic factors. Thus, the better question to ask is not whether weaker domestic conditions and reduced competitiveness will drive an AUD sell-off, rather if there is something unique to the current deterioration that will reduce the attractiveness of AUD as a vehicle for risk-positive views. We think the answer to this latter question is no. If anything AUD is even more attractive at present and we suspect reserves managers may be heavy buyers which could catch other segments of the market off-guard. Given that our base case is for diminishing tail-risk stemming from Europe in the quarters ahead, this means that a new cyclical high in AUDUSD is in store. We believe investors well underestimate the risk that the move could take the pair beyond 1.20.

AUD draw-downs come on the back of contraction in risk appetite and asset market declines, not domestic factors.

Since the onset of the global financial crisis in 2008, there have been three major draw-downs in AUDUSD. First, the pair collapsed from just beneath 1.00 to as low as about 0.60 surrounding the failure of Lehman Brothers. Second, AUDUSD traded from 0.93 to 0.81 in the spring of 2010 as initial concerns on Europe began to build. Third, a decline from 1.10 to 0.96 was seen in late 2011 as the sovereign debt crisis entered its acute phase. Each of these episodes was characterized by sharp deterioration in risk sentiment, deleveraging among global investors and weaker asset market performance. As such, the sell-offs in AUDUSD were correlated with moves in equities (see Figure 1), with peaks and troughs in stocks largely matching those from the currency. Even during earlier phases of the long-term run-up in AUDUSD, this pattern largely held, with the pullback and subsequent rally in stocks in 2004 marking a similar move in the currency. Figure 2: AUDUSD and Citi ESI on AUD
AUDUSD"(LHS) 1.1 1 0.9 0.8 0.7 0.6 0.5 2007/12/31 2008/12/31 2009/12/31 2010/12/31 100 50 0 !50 !100 2011/12/31 Citi"Economic"Surprise"Index"! AUD"(RHS) 150 200

Figure 1: AUDUSD and S&P500

Sources: Reusters EcoWin

Sources: Bloomberg

Market Commentary

Shifts in the trajectory of domestic activity have been a much less reliable indicator for AUD. Our Economic Surprise Index (ESI) for Australia provides a reflection of the evolution of underlying data flow. However, tops and bottoms in the ESI have been poorly matched with those from AUD in recent years (see Figure 2). In these episodes of AUD collapse, AUD was overvalued by many PPPcriteria. However, it seems more logical to suggest that the AUD drop in these periods was caused by the decline in global risk appetite, rather than by AUD overvaluation. Otherwise it would seem remarkably coincidental that risk appetite globally was collapsing just as AUD overvaluation was driving AUD downward. At best, one could argue that buying of risk ex post was stretched in all of these periods globally and in AUD but that puts focus squarely on whether global risk positions are overstretched, not whether hamburgers are more expensive in Perth than Peoria. The performance of the Australian economy relative to other major economies as reflected in the two-year interest rate spread fares somewhat better as an indicator for AUDUSD (see Figure 3). Interest rate spreads contracted sharply as AUD fell in both late 2008 and 2011. However, the spread between Australian and US two-year yields has been in a downtrend since 2010, while AUDUSD has traded higher over the same period. The implication is that deterioration in the underlying economic backdrop, lower RBA rates and reduced competitiveness are unlikely to drive AUD lower in a risk on world. The pre-eminence of swings in risk sentiment and asset prices in driving AUD seems to hold even on a more granular level. A simple short-term fair value model for AUDUSD can be constructed using a combination of external and domestic variables. In Figure 4 we show a comparison between fair value for AUDUSD (as suggested by real Australian interest rates, oil, VIX, the two-year interest rate spread with the US and equity prices) and moves in actual spot. We find that about 80% of AUDs moves can be explained by external factors with only 20% of the move attributable to domestic variables. This is not quite as skewed as the findings from a similar exercise for CAD, where nearly 100% of moves seem to be a function of external developments, but it suggests that domestic factors are at best second tier drivers for AUD. A tactical implication is that the threat to AUD from the ongoing slowdown in Australia should not be exaggerated and that RBA interest rate easing may provide less of a headwind than many in the market anticipate. Strains in the housing market and associated stress in the financial sector may have built in recent quarters amid a broad softening in the growth backdrop. Coupled with weakness in sectors exposed to exchange rate appreciation, this has seen the RBA lower interest rates and (even with the recent rebound in rate expectations) the market continues to price in a series of cuts moving forward. We are sceptical that this will hold AUD back in the year ahead, so we would buy into a dip if next weeks RBA policy-setting decision prompts a knee-jerk down move. Of course, there is a reasonable possibility that the Australian business cycle tracks the global cycle and risk appetite, but the evidence is that when there is a divergence the global factors tend to dominate.

Market Commentary February 2, 2012

Figure 3: AUDUSD and Two year spread

Figure 4: AUDUSD estimated and acutual

AUDUSD estimated and actual
1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 Jan Mar May Jul Sep Nov Jan Mar May 09 AUDUSD estimated [Model 1:regression] Jul 10 Sep Nov Jan Mar May Jul 11 Sep Nov Jan 12 Source: Reuters EcoWin

AUDUSD

Sources: Reuters EcoWin

Sources: MoF, CitiFX

A longer-term implication is that competitiveness should not be overemphasised as a constraint for AUD. No doubt the shift in the composition of Australian growth towards the resources sector has been associated with pain in manufacturing and other areas of the economy. However, there is little evidence as of yet that this has been a drag on AUD. Domestic factors look insufficient to reduce the attractiveness of AUD for riskpositive views. If anything, AUD looks more attractive now than has been the case in the past. As we note above, the run-up in AUD has taken the currency well beyond levels suggested by PPP and other measures of long-term valuation. This could present problems over time, but what many market observers miss is that AUD appreciation does not occur in isolation. Simply put, both the global and domestic backdrop looked better when AUDUSD was trading close to 1.00 in mid-2008 than was the case when it hit 0.60 late that year and the same can be said of the period surrounding the recent flare-up in the European sovereign debt crisis when the pair hit its cyclical peak near 1.10. Thus the better question to ask is not whether weaker domestic conditions will drive an AUD sell-off, but whether there is something unique to the current deterioration in the domestic backdrop that will be sufficient to reduce the attractiveness of AUD as a vehicle for riskpositive views. Ultimately, we do not believe this to be the case and we would not be surprised by accelerated capital inflows into Australia moving forward. Our reasoning follows: 1. The structural shift in foreign exchange markets towards increased focus on fiscal discipline should favour AUD, since Australia is better positioned than the G3 economies. 2. Australia is the deepest, most liquid market with tight links to Asia. Citis outlook is for only moderate slowing in Asia, so some investors who cannot invest in emerging Asia may continue to use AUD as a proxy to gain exposure. 3. Even with additional easing, Australian interest rates will remain above those elsewhere. No doubt Australian interest rates have more room to fall than is true for most major economies, but policy risks are hardly so asymmetric as recent money market price action would suggest. A significant flare-up in the European sovereign debt crisis is likely a precondition for the RBA to actually deliver on the priced in cuts, but recent Market Commentary February 2, 2012 3

history suggests this would trigger policy accommodation across the globe, not just in Australia. AUD buying from official reserves managers is likely to pick-up. This could catch other sectors wrong-footed. 4. Weakening in other sectors of the economy will not derail investment in the resources sector. A sharp pullback in both spot and long-dated futures commodity prices would be needed for mining companies to pare back investment plans. This is only a remote risk even with some softening in Asian activity, so investment in this sector in the years ahead is likely to total in the hundreds of billions. Some of this comes from abroad, so it is associated with outright AUD buying. These arguments may prove particularly persuasive to regional reserves managers, since their motivation for buying AUD is less dependent on expectation for price appreciation than is the case with private sector investors. Reserves managers have portfolios weighted more heavily in favour of G3 currencies than they would prefer and there is political impetus for buying of currencies like AUD since access to commodities is needed to ensure stable long-term growth. We have repeatedly argued that it is difficult to for reserves managers to diversify. From a big picture perspective this is true, since about 90% of reserves portfolios are still concentrated in G3 currencies and the better answer for reserves managers may simply be to accumulate fewer dollars and allow for more local currency appreciation. However, what marginal diversification that has occurred has clearly favoured the smalls. We estimate that the share of smaller currencies (including AUD, CAD and SEK) in official reserves portfolios climbed from about 1.5% in 1999 to nearly 5% by mid-2011. Holdings in small currencies as a percentage of total were roughly steady in between 1999 and 2007 and thereafter began to climb steeply (see Figure 5). This suggests reserves managers took advantage of the brief interruption in the trend towards USD weakness to up holdings of other currencies. Real time data on reserves management is scant, so it is not yet clear how reserves managers reacted to late 2011 USDstrength and the (likely temporary) slowdown in reserves growth, but we suspect the pattern from the post-Lehman period may repeat itself. Interestingly, the up move in reserves holdings of smalls began before the asset market recovery was fully entrenched and the topping out in USD over the post-Lehman period coincides with the pick-up in smalls accumulation. It is hard to determine if reserves managers will now lead the market in buying AUD, but it is likely that any significant buying from this source risks catching others off-guard. There has been limited participation in AUD appreciation thus far from the leveraged sector, while hedging by Australian exporters may likewise have lagged the move. This suggests a further up move in spot could trigger some market participants to chase the appreciation. As such, both the magnitude and speed of a further bout of AUD appreciation could surprise. Since our base case is for continued stabilization in market sentiment as perceived tail-risk stemming from Europe diminishes, this adds up to significant further appreciation in AUDUSD. For example, if EURUSD stabilizes close to 1.40 on diminishing tail risk in the coming year, a like-for-like move in AUDUSD would see a rise to about 1.14. Since we believe AUD is much better positioned to benefit from USD depreciation, we think the move will be greater than one-for-one. For reference, the overall appreciation in AUD from the November 2008 low 4 February 2, 2012

Our base case is for diminishing tail risk in the quarters ahead so a new cyclical high should be in store for AUDUSD. Markets underestimate risk for a move Market Commentary

above 1.20.

to present has been more than 8x that seen from EUR. This convinces us that a significant break beyond the previous cyclical high in AUDUSD is well within reach and markets likely underestimate the potential for an even greater move beyond 1.20. Options markets discount only about a 1 in 4 chance that AUD will be trading above 1.15 in one-years time, a 1 in 5 chance it will be above 1.20 and a 1 in 10 chance it will be above 1.25. We think the probability of a move into this range is higher than market pricing suggests, so we favour taking advantage of spot dips and the decline in implied volatility to enter longs.

Figure 5: Share of smalls as % of total reserves holdings

60 65 70 75 80 85 90 95 Dec-05 Weaker USD USD vs Smalls (LHS, Rebase 100 = Q1 99) Share of Smalls as Pct of Total Reserves Holdings (RHS) 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Source: Reuters EcoWin

Market Commentary February 2, 2012

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G10 Steven Englander Greg Anderson Andrew Cox Valentin Marinov Todd Elmer Osamu Takashima Issei Suzuki Asia Patrick Perretgreen Gaurav Garg CEEMEA Wike Groenenberg Luis Costa Leon Myburgh Coura Fall Latin America Dirk Willer Ram Bala Chandran Monty Gandhi Akhil Lodha Technicals Tom Fitzpatrick Shyam Devani Jim Zhou Head of Technicals Strategy Technicals Strategy TechnicalsStrategy 1-212-723-1344 44-207-986-3453 1-212-723-3469 thomas.fitzpatrick@citi.com shyam.devani@citi.com jim.zhou@citi.com Head of LATAM Strategy LATAM Strategy LATAM Strategy LATAM Analyst 1-212-723-1016 1-212-723-3081 1-212-723-3020 1-212-723-3619 dirk.willer@citi.com ram.balachandran@citi.com chintan.gandhi@citi.com akhil.lodha@citi.com Head of CEEMEA Strategy CEEMEA Strategy Sub-Sahara Strategy Sub-Sahara Analyst 44-20-7986-3287 44-20-7986-9757 27-11-944-1830 27-11-944-1889 wike.groenenberg@citi.com luis.costa@citi.com leon.myburgh@citi.com coura.fall@citi.com Head of Asia Strategy Asia Analyst 65-6657-1501 65-6657-1501 patrick.perretgreen@citi.com gaurav.garg@citi.com Head of G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy 1-212-723-3211 1-212-723-1240 1-212-723-3809 44-20-7956-1861 65-6328-2932 81-3-6270-9127 81-3-6270-9114 steven.englander@citi.com gregory1.anderson@citi.com andrew.cox@citi.com valentin.marinov@citi.com todd.elmer@citi.com osamu.takashima@citi.com issei.suzuki@citi.com

Market Commentary February 2, 2012

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