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  • The recent oil price rally has fueled the recovering commodity currencies like the Canadian and Australian dollar.

  • But has the market got ahead of itself with this rallying commodity currencies?

  • One man who thinks so is Steven Saywell, global FX strategist at BNP Paribas.

  • Steven, what is it that that has caused the rally in recent commodity price currencies?

  • Well, we think it really gets down to one point and that's the Chinese recovery.

  • Certainly if we look at the tail end of 2015, expectations for Chinese growth were fairly muted.

  • But, actually what's happened in 2016 is that growth has exceeded expectations.

  • That's led to stronger demand for commodities and we've seen quite a nice rebound led by oil

  • but also other commodities, specifically things such as iron ore.

  • Okay, so if we take a look at your first chart, it shows us the Australian dollar,

  • which is a commodity currency driven by iron ore prices.

  • And it's showing basically that the red line shows the actual spot rate for the foreign exchange rate compared to the US dollar,

  • and then we have the BNP Paribas model number that shows the blue number,

  • that shows basically it's currently undervalued.

  • So, why do you think that is?

  • Sure. Well, I should highlight it. So the blue line here is one of our flagship models. It's called BNP Paribas CLEER.

  • It gives a medium term equilibrium level of a currency.

  • What we think has happened here is that the Australian dollar is currently, significantly higher than the equilibrium level would suggest.

  • I think there's two factors there. One is the commodity prices have accelerated quite significantly.

  • We don't think that is sustained. So we think that falls back.

  • Secondly, until very recently, the reserve bank of Australia had kept interest rates very high as well, too.

  • They've started to ease policy now and we're starting to see the Australian dollar converge back to the level signalled by the model.

  • Okay. So if we take a look at the second chart that you've brought out.

  • The second chart shows us the market position and how it's changed.

  • So we've had, this is the exchange rate with the Canadian dollar versus the US dollar and the Australian dollar or US dollar.

  • Canadian obviously being an oil-fueled currency as well.

  • And we can see that the positioning has changed in the market,

  • so we've gone from quite a strong, short position at the beginning of the year to quite a strong, long position.

  • So, do you think the market has got it wrong? Or why has it switched?

  • Well, this is interesting. If we look at the history of these two commodity currencies, and remember the zero line here is a neutral position.

  • You can see that for the past 12~15 months, the markets pretty much exclusively held a short position.

  • That changed quite dramatically from the beginning of 2016. I think driven by the commodity price rally.

  • We're now at a level where the market is, we would say caught long of both of these currencies.

  • The reason we say caught is that if commodity prices do fall back,

  • which they're starting to already and it's consistent without expectations,

  • the market will then scramble to reduce these long positions and that will accelerate the move to the downside

  • for both the Australian dollar but also the Canadian dollar.

  • Okay, so then if we look at your third chart, when we talk about where the market is

  • and where you might suggest that people could take advantage of the trend that you think is coming.

  • Um... we take a look at the Australian dollar and compare it to the Euro.

  • So that's the red line here and the blue line is showing us the 2-year interest rate swap spread,

  • which traditionally there is a relationship between those although we have seen some gaps in a few points.

  • So, what is this chart telling us?

  • Well, certainly the underlying philosophy here is that there's a very strong relationship or correlation between

  • short term interest rate movements and currencies.

  • Secondly, traditionally, the Australian dollar tends to be quoted against the US dollar,

  • and that's what the original model told us that equilibrium lies to the downside around 67 cents.

  • That's a great trade over the medium term, but in the short term, we think the Euro will continue to do very well.

  • So, one of the favorite trade recommendations we have is long with the Euro against the Australian dollar.

  • And this chart or the relationship here backs that up very clearly.

  • You can see the blue line, which is the interest rate differential is moving significantly in favor of the Euro,

  • and that's pushing the Euro versus the Australian dollar higher.

  • What you can also see is the interest rate is telling us there's more to go on the upside.

  • So we think being long the Euro versus the Australian dollar is a very good trade recommendation.

  • Okay. And then if we take a step back and look at what investors are watching.

  • So, I mean we've had a stronger recovery in commodity prices,

  • we've had a weakening expectation of the Fed and what their rate hikes might be.

  • And we've had some recovery in sort of the Chinese or some pleasant surprises around Chinese economic data

  • in the past few months that have been fueling this.

  • What are the things that if an investor had to pick one or I guess at most two things to watch of when this might turn.

  • What would those be?

  • Okay. Well, if I had to name two factors here, particularly in the case of the Australian dollar I'd name the following to 2 points.

  • One. What happens to iron ore prices? Does it fall back?

  • Do they fall back as we anticipate?

  • And secondly, what happens on the interest rate front? Is the reserve bank of Australia likely to cut interest rates again?

  • We think they do potentially as early as June.

  • If either, or both of those factors happen, the Australian dollar will weaken.

  • Thanks very much.

The recent oil price rally has fueled the recovering commodity currencies like the Canadian and Australian dollar.

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