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Global

Gl b l Tactical
T ti l
A t Allocation
Asset All ti
GTAA
The Case Against the Australian Dollar

Ad Hoc
April 15th , 2010

Damien Cleusix
d i @ l 6
damien@clue6.com

Clue6 The Case Against the Australian April 15th , 2010


Executive Summary 1

“Jusqu’ici tout va bien, jusqu’ici tout va bien… l’important c’est pas la chute… c’est l’atterissage.”
(la Haine, M. Kassovitz)

The Australian Dollar is by far the most overvalued currency in the G20.

The Australian economy is relatively small and has had a current account deficit during most of the past 50 years. It has a high
operating and financial leverage with 70% of the market being either commodity or financial related (30% and 40%
respectively).
respectively)

Commodity prices are highly dependent on the continuation of the nascent Chinese credit bubble.

The financial ppart of the equation


q feels like an house of cards.

Assets have risen substantially in the past 20 years and have fostered more risk taking and less savings. Their overvaluation is
now so big that attraction should soon exert its influence again. Houses in particular might be up to 50% above fair value.

Given the high leverage of both households and financial entities this will have very nasty consequences.

While the public sector is in good shape, this won’t last long when the downturn starts in earnest and the private sector will have
to be bailed-out.

Speculation and carry-traders are betting heavily on a continuation of the AUD uptrend while there are heavy non-resident
AUD bonds holdings to mature in the near-term.

The trend has deteriorated but should be analyzed


y carefully
y to avoid losing
g its shirt in a p
possible ((but not p
probable)) move
toward parity against the USD.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Valuation 2
Chart 1 AUD/USD Fair Value Model

Source: IMF, OECD, Clue6

The AUD is, by far, the most overvalued developed markets currency with a 30% deviation from fair value.

Valuation in itself is not very informative except when the deviation becomes as important as today.

In the current configuration, one should act on any technical deterioration and lighten when sentiment is too bullish and the cross is nearing
the top of its rising short-term channel.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 3
Chart 1 Australia Current Account Deficit Chart 2 AUD and Australian Terms of Trade

Source: RBA, Clue6 Source: RBA, Clue6

Australia is a small open economy. It has run a current account deficit during most of the past 50 years. The deficit reached historical highs in
2008 and is now rebounding after having corrected during the end of 2008-beginning of 2009 global slowdown (Chart 1).
1)

Australia terms of trades have been affected positively by the commodity markets structural upswing that started in 2002 (Chart 2). The
Australian dollar ups and downs have historically been well correlated with the term of trades.

But is it justified? It was when Australia was highly dependant on commodities exports but now it is mainly a financial
financial-driven
driven economy…
economy

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 4
Chart 3 ASX Sectors Weight Chart 4 Australia GDP Growth Contribution

Source: Macquarie, Clue6 Source: RBA, Clue6

The financial and property sectors are representing more than 40% of the Australian market while commodities and oil 30% (Chart 3). Note that
more than 70% of the market capitalization are in those 4 sectors.
sectors Diversified? Not really.
really Cyclical? Highly and as we will see later,
later the financial
and property sectors are going to experience an “accident” in a not so distant future… Australia has a high operating leverage.

The Australian economy is very dependant on households consumptions, private gross fixed capital formation and exports (Chart 4). The first
two have been and will continue to be very dependant on a build up in leverage and rising assets price to continue to contribute as positively as they
have while the later is dependant principally on China (the continuation of its nascent bubble dynamic) the commodities price
have, price-fixer
fixer of our time.
time

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 5
Chart 5 Households Assets to Disposable Income Chart 6 Households Saving Rate

Source: RBA, Clue6 Source: RBA, Clue6

Households have a high asset to disposable income ratio(Chart 5) in comparison to most developed economies.

Feeling richer, households have started to cut the proportion of their income they save (Chart 6). This is a phenomenon we have seen in most
Anglo-Saxon economies (and elsewhere in the late stage of the global credit bubble).

The problem is that both financial and non-financial assets are overvalued and could (not a prediction) fall up to 50% from current levels.

This would be catastrophic given the financial leverage of the Australian private sector…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 6
Chart 7 Household Debt to Disposable Income Chart 8 Banks and Other Financial Corporations Debt

Source: RBA, Clue6 Source: ABS, Clue6

Australia has been praised for its lack of public leverage by most commentators. Yet, with a nearly constant current account deficit, it has been
spending more than what it was earning. The culprit: the private sector…

The debt to disposable income is one of the highest in the world at almost 170% (Chart 7).

The financial sector has also been increasing its leverage quickly (Chart 8) and, as showed later, is increasingly relying on foreign source of
funding paving the way ultimately to a short squeeze.

Debt is not a problem as long as the assets financed are rising but as elsewhere, Australian assets will mean-revert…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 7
Chart 9 Financial Institutions Fees Earned from Households Chart 10 Households Mortgage Activity

Source: RBA, Clue6 Source: ABS, Clue6

Financial institutions have been willing to lend to thirsty households, earning big fees (Chart 9).

Normalizing mortgage rate using workers compensation growth one can see that rates are currently negative (Chart 10).

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 8
Chart 11 Households Mortgage Activity Chart 12 Numbers of Dwellings Financed

Source:ABS, Clue6 Source: ABS, Clue6

Households mortgage activity has thus been rising rapidly (Chart 11).

The number of houses purchased has been higher that what would have been the case otherwise (Chart 12). There are no natural pent up
demand here…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 9
Chart 13 Mortgage Average Loan Size Chart 14 Households House Equity

Source:ABS, Clue6 Source: ABS, Clue6

The size of mortgage taken has increased rapidly (Chart 13) and the owner’s equity in real estate has declined from 90% in 1990 to 70%
today (Chart 14).

With regard to owner’s equity, one should remember that this is not what the average mortgage holder holds but is computed using the stocks of all
houses, even those without mortgages. In consequence, the owner’s equity of mortgage holders is much lower and would be wiped out on a
meaningful housing correction…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 10
Chart 15 Lending for Houses Bought as an Investment Chart 16 Mortgage Market

Source: Standard and Poor’s

Source:ABS, Clue6

Lending for housing speculators has risen tree-fold since 2002 (Chart 15). We have yet to see a condoflip.com website but our contacts in
Australia are talking about a real frenzy…

We are even seeing the emergence of low-doc loans (Chart 16)…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Macro 11
Chart 17 Fixed Rate Mortgages Proportion

Source: ABS, Clue6

Mortgages are also adjustable rates in their majority (Chart 17).

Rising rates would be bad…

Clue6 The Case Against the Australian April 15th , 2010


AUD: Housing 12
Chart 18 Median House Price (Nominal)

Source: M. Keen

All what was said before would be bad even if the housing market was fairly valued but…

Real estate in Australia is much more expensive than in the US in 2007. It would have to fall by approximately 50% to reach fair value
(Chart 18)

From 1972 real rent almost flat while house price have risen 3 times and construction cost by 1.3 times.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Housing 13
Chart 19 Australian Housing Markets Valuations Chart 20 Housing Markets Affordability

Source: OECD, Clue6 Source: Demographia

The price
i to rent ratio
i is
i 76%
6% above average while i the price
i to income
i ratio
i is
i 50%
0% above its
i historic
i i average (Chart
(Ch 19).
19) Remember
b that
h we
are using an average and the average has been distorted by the high prices reached since 2002…

Not surprisingly, of the 20 most overvalued Anglo-Saxon city according to Demographia, 12 are in Australia (Chart 20).

Clue6 The Case Against the Australian April 15th , 2010


AUD: Housing 14
Chart 21 Australian Housing Markets Mortgage Payments Chart 22 Households Interest Payments to Disposable Income

Source: Demographia

In some cities,
i i more than 50%
0% off the median
i income
i i needed to pay the mortgage on a median
is i priced
i house (Chart
(Ch 21).
21)

Interest burden, while lower than in 2007 (thanks to lower mortgage interest and a move toward floating-rate mortgage) remains very high (Chart
22).

Clue6 The Case Against the Australian April 15th , 2010


AUD: Sentiment 15
AUD/USD and Non
Non-Commercials
Commercials AUD/USD and 3 Months 25D
Chart 23 Future Net Position Chart 24 Risk Reversal

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

Non-Commercials
C i have a big i net long AUD
A position
i i (Chart
(Ch 23).
23) We have
h no divergence
di yet but
b the
h net long
l position
i i isi sufficient
ffi i to justify
j if a
decline of the AUD to at least the 0.85-87 area.

There are no divergences on the risk reversal (Chart 24). The RR remains below the pre-August 2007 lows of -1.3 though.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Sentiment – Seasonality 16
Chart 25 TFX Net Retail AUD/JPY Margin Position Chart 25 AUD/USD TR Monthly Seasonality

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

“Japanese
Japanese Housewives
Housewives” have cut most of their long position in a surprising move (Chart 25).
25) Such behavior have preceded corrections more
often than not.

While April and early May tend to be supportive for the AUD, the period into the middle of October has not been good (Chart 25).

Clue6 The Case Against the Australian April 15th , 2010


AUD: Liquidity 17
Chart 27 AUD Uridashi and Eurobonds Market Chart 28 Overseas Financial Institutions AUD Turnover

Source: Bloomberg, Clue6 Source: RBA, Clue6

Looking at liquidity,
liq idit it is always
al a s important to have
ha e a look at bonds in AUD sold to non-resident,
non resident particularly
partic larl in Japan (Uridashi) and Europe
E rope (AUD
Eurobonds) (Chart 27). There are heavy redemptions coming and negative net issuance in the past have not tended to be kind to the AUD…

One can also see that there are a lot of people playing the carry-trade. Overseas financial institutions AUD turnover has increased a lot since
2000 (Chart 28). Spikes in activity have tended to correlate well with subsequent corrections.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Central Bank Intervention 18
Chart 29 AUD/USD And Royal Bank of Australia Interventions

Source: RBA, Clue6

The RBA has started to increasingly intervene every time the Aussie moves above 0.92.

Expect heavy intervention if we move to 0.95 again.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Graph 19
AUD/USD

Shoulder
Shoulder
Head

We are short and would


increase on a move
toward 0.945-0.95.

Would also sell more on


a move below 0.90.

Approaching the pat 6 months high.

Best to be played with a 3-4 months backspread rebalanced every 2 months (selling in money put on the AUD and buying more out of the money
put on the AUD).

We would even start to buy some very deep out of the money puts 0.8
0 8 and below every month when at the top of the channel and the equity
markets are showing sign of distribution as they are now. This was advised in the summer of 2007 on the NZD and both AUD and NZD in
2008… We were playing black swans and we feel one is coming here in 2010-2011.

Clue6 The Case Against the Australian April 15th , 2010


AUD: Conclusion 20

The Australian Dollar is by far the most overvalued currency in the G20.

The Australian economy is relatively small and has had a current account deficit during most of the past 50 years. It has a high operating and financial
leverage with 70% of the market being either commodity or financial related (30% and 40% respectively).

Commodity prices are highly dependent on the continuation of the nascent Chinese credit bubble.

The financial part of the equation feels like an house of cards.

Assets have risen substantially in the past 20 years and have fostered more risk taking and less savings. Their overvaluation is now so big that
attraction should soon exert its influence again. Houses in particular might be up to 50% above fair value.

Given the high leverage of both households and financial entities this will have very nasty consequences.

While the public sector is in good shape, this won’t last long when the downturn starts in earnest and the private sector will have to be bailed-out.

Speculation and carry-traders are betting heavily on a continuation of the AUD uptrend while there are heavy non-resident AUD bonds holdings
to mature in the near-term.

The trend has deteriorated but should be analyzed carefully to avoid losing its shirt in a possible (but not probable) move toward parity against the
USD.

Clue6 The Case Against the Australian April 15th , 2010

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