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Premium: How high can the Aussie fly?

The Aussie Dollar has had a stormer since the Covid lows last March.

In June last year, we asked how high can the Aussie fly? 👇

For Australia, (and the AUD), all roads point higher in the near term.

Beyond this, much will depend on how brave the world’s policymakers are willing to be...

AUDUSD was trading just below 0.70 back then

Policymakers have definitely been brave with their promises of spending and investment, and the Aussie has enjoyed a strong commodity-driven tailwind ever since, with AUDUSD tagging 0.80 in Feb & currently trading 0.7750.

It's time to ask the How high? question again...

Westpac expect the strength to continue 👇

Record Chinese steel production, record steel product production, falling iron ore port and steel product inventory and rising steel production margins, it tells you that the strength in iron ore has been driven by super strong demand in the face of limited supply rather than speculation.

Thus, it’s not a surprise that iron ore markets have jumped higher again.

Indeed, the midpoint of our fair value models ended last week at 0.8325 with the A$ deemed to be cheap below 0.82 using Friday closes for our export weighted commodity price index.

We stick to the view that the A$ remains significantly undervalued versus record high commodity prices.

We remain long from below 0.7680 and happy to add on weakness.

Long AUD at 0.7680; add on dips to 0.7580; stop below 0.7525

Targeting 0.82 by December, and 0.85 by March 2022.

Explained in more detail here 👇

Their fair value model seems to have a strong weight towards continuing strong commodity exports (particularly of iron ore) to China...

And iron ore, like most commodities, has seen a staggering rally this past year...

But China has had enough of the high prices 👇

Newsquawk

The intervention worked and prices are beginning to drop...

They've really been churning it out in Q1, and (alongside other activity) emissions are way up...

CarbonBrief

Up enough for pollution curbs to come into play too...

 #China Tangshan city tightens #steel output curbs on pollution from May 18 to 20.— CN Wire (@Sino_Market) May 19, 2021 

More iron ore supply is coming to market:

Everything is stacking up for a pause in this broad commodity rally, and pullbacks are already underway.

Copper demand looks to have peaked for now too 👇👇

What about the commodity 'supercycle'?

Eduardo Bartolomeo, chief executive of Brazil’s Vale, said the record surge in iron ore prices over the past year was very different to the boom of the early 2000s, which was driven by China’s rapid industrialisation.

“In the last supercycle we had urbanisation in China.

It was a structural change. A shock in demand,”  

“We are not talking about a huge shock in demand now.

I would say it is marginal. It is not a shock.”

But he added that, with big global economies revving up and iron producers running at or near capacity, prices could remain elevated until 2023.

“Although there is strong talk about cuts, production is still going up in China and now you have Europe coming back and the US announcing a huge stimulus package. There are also restrictions on supply,” he said.

“This market is going to be tight for a while. At least two years.”

Prices could remain 'elevated'.

Against what benchmark?

The pre-Covid value of ~$80-100 or current pricing of over $200?

The latest BofA fund manager survey strongly suggests that we are seeing peak optimism in commodities...

And this has been backed up by positioning...

So, there you have it.

Commodities have peaked so we should just sell the Aussie, right?

"Maybe, baby, let's take it slow..."

From a macro perspective, the recent period has been extremely challenging.

There is no real macro regime to speak of, no major trends to follow, but a huge amount of data and information to digest...

I do think the narrative will shift soon.

Now that the scene is set, we're going deeeeper.

Commodities first.

What's driven the higher prices to this point?

There's a few factors...

#1 Initial lockdown snapback effect: When Covid hit, companies presumed there would be no demand, cancelled their orders, processing plants shut down, peak uncertainty meant  firms deciding to just run down inventories and wait for 'news'. What else would they do when faced with such uncertainty?

Then, government support came in, we were all bored at home and bought loads of stuff online to get us through lockdown.

Inventories gone. Shortages everywhere.

Companies were taken by surprise and began fighting for the same goods and the same shipping spots.

📞 "Listen mate, You want to be first, you've got to pony up. Buy in bulk and/or pay the premiums, right?"

On average, firms did both.

Speculators spotted the opportunity too and the whole loop fed on itself, driving prices higher.

#2 The commodity super cycle:

Fully priced already, innit?

OK. Full answer, the demand for commodities is likely to remain strong as infrastructure spending and the green revolution take shape in the coming years.

Does that justify current pricing?

Or does the 'bullwhip effect' await first? 👇

Bullwhip Effect

The bullwhip outcome 👇

Yes, I know it's an extreme example. It is the perfect example of a worst-case outcome though...

While such an extreme snapback in commodities would be surprising I can't help wondering just how much stuff was over-ordered in that uncertain panic and how much hasn't yet worked its way into the feedback loop...

Not talking about the stuff that was ordered to meet the real demand at the time, I'm thinking about the orders that were made to catch up, keep up and get ahead of the competition...

Non-commercial positioning suggests prices are unlikely to see another leg higher unless a fresh catalyst materialises

#3 Pent-up demand:There are $20 gazillion dollars in savings, just waiting to be UNLEASHED into the economy....

Who has those savings and will they actually spend?

By the time we expect economic life to normalize around mid-2021, we estimate that roughly 8% of the excess savings will have been used to pay down debt, 39% will have been used to buy illiquid assets, and 53% will sit in the more liquid form of bank deposit accounts.

Of the excess savings that remain in liquid form, we estimate that 21% are held by the bottom two income quintiles combined, 16% by the middle quintile, and 63% by the top two quintiles.

Put another way, only 37% of the 'liquid' savings are held by those with the highest propensity to spend.

There is definitely some pent-up demand, and GS think that '1-3pp is a plausible range for the impact on GDP growth.'

Obviously, the focus here is on the U.S. due to their stimulus measures.

Last crisis, China 'saved the world' with their massive spending splurge...

This time they're tightening instead...

China's credit impulse has just turned negative 👇

Historically, that hasn't been great news for commodities...

Real estate contributes to about 29% of China’s economic output if its wider influences are factored in, according to a joint research by Harvard University and Tsinghua University.

In previous times, China would undertake massive state-backed construction projects (without regard for profitability), but even this is being curtailed due to concerns over high government debt levels...

The CCP have a great opportunity to ease up on this spending in 2021.

Base effects mean this years GDP growth takes care of itself. No need to bump the GDP with new construction projects.

Press pause, manage the debt growth...

They're already feeling the heat and the PBoC’s Lu Jinzhong today suggested some policy responses to higher commodity prices, which have ‘aroused widespread concern from all walks of life’. 

One such policy suggestion is to ‘enhance exchange rate flexibility, appropriately appreciate the RMB and resist import effects’. 👇

Is Lu Jinzhong jawboning commodities lower, or the currency higher?

So they're apparently bridged until August, but then what?

The Huarong 'game of chicken' still has some runway to play out...

“The regulator is saying there is going to be some serious reform in the financial system”

The investors are saying:

“I bet you don’t have the courage to let this default happen because there will be a crisis.”

The Chinese government, which has stayed quiet about a rescue, is in the early stages of planning a reorganization that will require foreign and Chinese bondholders alike to accept significant losses on their investments, according to two people familiar with the government’s plans.

Huarong is a tricky balancing act.

Too big to fail of course, but high profile and the perfect opportunity to send a message...

Will they take the risk?

Summing up, there's a decent chance that the commodity rally is overdone.

It's built on demand assumptions that will soon be tested, alongside the broader China construction slowdown due to their self-imposed constraints.

BUT (there's always a but)...

The U.S. is splurging instead, and this crisis isn't like '08 when demand was decimated, millions lost everything and essentially had to start their lives over again.

That hasn't happened this time.

We have this instead 👇

Pre-Covid: 

“Last year we were laying off,” said Pete Trinidad, president of the United Steelworkers Local 6787 union, which represents roughly 3,300 workers at a Cleveland-Cliffs steel mill in Burns Harbor, Ind.

Post-Covid:

“We are running 24/7 everywhere,” said Lourenco Goncalves, the chief executive of Cleveland-Cliffs, an Ohio-based steel producer that reported a significant surge in sales during its latest quarter. “Shifts that were not being used, we are using,” Mr. Goncalves said in an interview. “That’s why we’re hiring.”

“Everybody was offered jobs back. And we’re hiring now. So, yes, it’s a 180-degree turn.”

That all sounds wonderfully positive.

Has the underlying economy changed drastically enough to warrant the 180º shift...?

Higher growth and higher inflation is now the consensus

And the nature of that inflation is still unclear...

High prices cure high prices in commodities, but if inflation runs too hot for too long, the spotlight turns to the Fed to do something about this economic overheating/out-of-control inflation (and cut the recovery off at the knees...)

Whether the Fed actually announce the taper or hold off, the market will be closely monitoring Fedspeak until the pre-meeting blackout period and the May inflation data will be published five days

FOMC Minutes got far more attention than they really deserved, with some getting very excited about these comments

“A number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”

If, might, at some point, upcoming meetings, begin discussing a plan...

Hardly a strong commitment, but the market focus has undoubtedly shifted to tapering now (even though the immediate kneejerk reaction was subsequently reversed)

This was also noted 👇

“A number of participants remarked that supply chain bottle-necks and input shortages may not be resolved quickly and, if so, these factors could put upward pressure on prices beyond this year.”

“. . . a couple of participants commented on the risks of inflation pressures building up to unwelcome levels before they become sufficiently evident to induce a policy reaction.”

How far can the Fed stretch the definition of transitory?

Do they focus on the cause (bottlenecks) or the symptoms (inflation data & expectations) to decide when to act?

As we move into the summer, goods demand is expected to normalise as people spend more on experiences and going out instead...

Quickly recapping...

Commodity pricing has likely peaked, ongoing global goods demand is uncertain and Fed taper fears are creeping in...

In FX land, this was last weeks IMM (via Danske Bank)

Approaching 'stretched short' positioning

What are the retail crowd doing?

IG / DailyFX

FXSSI

Retail are favouring long USD, especially against CAD...

Which is pretty insane really.

Interest rate differentials will play their part, and this is where the CAD has seen a double tailwind and outperformed.  

"We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.

Based on the Bank’s latest projection, this is now expected to happen some time in the second half of 2022".

Two rate hikes are already priced in for '22, & Macklem noted CAD strength in a recent Q&A, although there was no indication that it was a concern right now...

In Australia, it looks like there will be a far longer runway for liftoff.

RBA projections have 2024 'at the earliest' before conditions will be met for rate hikes...

Trading perspective:

Getting into the tails with USD weakness now.

1.20 is a big level in USDCAD.

I can easily envisage a complete stitchup through there into the 1.19s followed by a quick reversal back into the 1.20s, and then reassess the factors at play.

I like USDCAD for all the wrong reasons. It's moved further so it can mean revert further, but the macro picture is quite supportive of CAD strength.  

AUDUSD I like from a macro perspective: China construction slowdown and a higher bar for rate hikes.

But it hasn't moved as excessively and positioning isn't as stretched...

In the current (non) macro regime, it's hard to generate high conviction trade ideas.

There is plenty bubbling under the surface though.

It's unlikely that we'll see anything definitive materialise until the big U.S. data in June (NFP, inflation) ahead of FOMC on the 16th.

If the market flips onto the next narrative (taper) and the Fed is perceived to be stepping in to curb inflation early, then these cyclical trends should come under pressure, and given the positioning USD would likely benefit.