As I've outlined previously, there were a couple of key factors which helped move the AUD from being the worst performing currency earlier in the year to one of the best. First was the change in domestic data from mostly disappointing to some better activity readings. Second was the realisation that China was not heading towards a hard landing and was in fact strengthening. The final point was the rapid rise in US yields was mitigated by the FOMC decision on hold course with current policy.
On the first point, the Australian domestic data continues to be a bit better. But the big problem is that we are currently getting a lot of visibility on sectors of the economy that are required to improve in order to ensure that growth doesn't slip further.
For example, retail sales have picked up and building approvals have lifted sharply as shown in the chart on the left.
But what we haven't got as much visibility on is business investment, which is shaping up as the critical drag on activity heading into 2014. While business confidence has lifted, businesses assessment of conditions and capacity utilisation remain very poor, suggesting this remains a huge risk to growth forecasts.
As the chart on the left shows, stronger consumption and housing construction is no guarantee that growth will not be weaker in 2014. I think that business investment will be enough of a drag on growth next year that on average growth should be around ~2%.
This is below the consensus outlook and the recently revised RBA forecasts of ~2.5%. To be sure, the most recent RBA statement on monetary policy was probably on the dovish side, with the uncertainty about the path of business investment the key issue driving whether they may need to cut rates further.
And for my money, markets are too confident about the prospect of the next move in the cash rate being up next year. If anything it will either be unchanged or a bit lower.
Labour market data is a lagging indicator, but it is released relatively early in the data cycle and is probably the single most important indicator for policymakers.
The poor growth in Australian employment, which has slipped over the past few months, suggests things are soggy enough to remain concerned. Indeed, those who are hawkish should note its unlikely that the RBA will hike until there is a solid indication of much better employment growth coming through the pipeline.
The outlook for China continues to be pretty stable. There are no demons in the activity data, with the latest reading on steel production looking strong. Crude steel output should rise by ~7.5%YoY when the official statistics are released, which is probably even still much better than anyone expected.
From a policy perspective, there seems to be mostly positive commentary coming out about the 3rd Plenum meetings which are underway, although major reforms are unlikely.
It should also be noted that SHIBOR rates have fallen again, although looks to be moving in a new, higher band, which would represent a small tightening of monetary policy. But this is not worth panicking about.
There does appear to be a more meaningful, change in the outlook for policy in the US following the most recent data and statement from the FOMC. This makes tapering of asset purchases likely in the next couple of meetings.
The most recent employment data were strong, with non-farm payrolls now averaging over 200kt over the last 3 months (with big revisions to August data). This has previously been suggested as a threshold for tapering.
GDP data were mixed and ISM surveys strong, but more important is the FOMCs assessment of higher interest rates on housing market activity. As I posted here, they are not so alarmed and are probably comfortable with 10-year rates at 2.5-2.75%.
This should change the direction of relative AUD/USD yields, which are influential on FX movements. Although as the chart on the left shows, its not 100% consistent over time.
I think there were a couple of factors that drove the currency so much lower in April when yields dropped compared to the preceding 12months.
First was the element of surprise from the RBA, with the rate cut in April not expected.
Second was the overlay of a huge amount of concern about a hard landing in China, which is now off the cards for now.
So even though I expect yield differentials to narrow, would I expect the current to drop back to where it was? I tend to think it might be a bit harder to knock over to sub-90 levels, because the China part of the equation is much better at present.
But that said, I would still be short the AUD.