Commodity Currencies Update: CAD to Outperform

We have revised up our forecasts on Canadian dollar given recent strong economic outlook and upbeat BOC statements. We believe CAD should strengthen against both AUD and NZD as domestic recovery gains traction. When the BOC begins it tightening cycle, probably at the end of 2Q10, the pace would be swift if accompanied with positive indicators. We have also modestly raised Australian dollar's outlook for 2Q10 and 3Q10 as the country's growth has been robust and undoubtedly the strongest among developed economies. For New Zealand dollar, we currently leave our forecasts unchanged, given mixed economic data released in recent month, but will closely monitor changes in news flows.

AUDNZD surged to a decade-high above 1.3 last week after the RBA raised the cash rate by +25 bps to 4%. From the technical point of view, Australian dollar may strengthen further. Considering fundamentals, Australian economy should remain stronger than that in New Zealand. However, we believe most of the good news has been priced in and further upside is limited

Strength in Australian dollar has been driven by outperformance in Australian economic data over New Zealand ones. For instance, unemployment rate in Australia peaked in July and fell to 5.3% in January. However, unemployment continues to rise in New Zealand with the rate rising to 7.3%, the highest in 10 years, in the fourth quarter.

Housing market activities is losing steam in New Zealand, although property prices remain strong. REINZ's data showed that house sales have dropped for 4 months and reached a record low of 3666 units in January 2010. On the contrary, housing data still shines in Australia. The home sales value index rose +1.8% in January with growth seen in all major regions. We believe the difference in job market conditions contributed greatly to property markets.

The RBA is the first central bank that delivered 4 rate hikes after the recession in 2008/09. The latest RBA rate hike has widened the interest rate differential between Australian and New Zealand debts. However, as the RBA stated in the latest meeting statement, 'labor market data and a range of business surveys suggest growth in the economy may have already been at or close to trend for a few months', the central bank may need to see upcoming data to rise 'above-trend' before justifying another rate hike. We believe the interest rate differential will then get narrow as the RBNZ probably start raising interest rates in mid-year. In fact, employment increased only +0.4K in February following a rise of 56.5K in the previous month. The unemployment rate edged higher to 5.3% as January's reading was revised to 5.2%. This is the first sign of moderation in economic growth in Australia, probably driven by rate hikes and removal of stimulus measures.

Both the RBA and RBNZ are inflation targeters with medium-term inflation targets at 2-3% and 1-3%, respectively. Current level of AUDNZD indicates New Zealand's CPI may stay at the lower end of the target range for some time. This implication is unjustified and contrary to RBNZ's outlook.

In the latest RBNZ meeting, policymakers decided to leave the OCR unchanged at 2.5% and reiterated the stance to 'removing policy stimulus around the middle of 2010'. While being cautious to domestic economic outlook, the central bank raised CPI forecasts to 2.3% and 2.8% for 2010/11 and 2011/12 respectively.

Robust Chinese economic growth has benefited Australia more than New Zealand over the past few years. Therefore, policies to cool down the overheated Chinese economy should affect Australia more negatively than New Zealand.

The market has been speculating China is about to hike interest rates for the first time in more than 2 years. According to the National Bureau of Statistics, heading CPI exceeded market expectations and rose to a 16-month high at +2.7% y/y in February. Although lending fell -34.5% y/y to RMB700.1B during the month, expansions in industrial production, retail sales and fixed asset investments, all above +20%, indicate the economy has overheated.

Should the Chinese government really step up tightening measures, the Australian economy should show faster moderation than New Zealand's.

We are bullish on Canadian dollar in the medium-term (3 months) although the Bank of Canada did not change the policy rate. In the accompanying statement, the central bank did drop the references that 'overall risks to its inflation projection 'are tilted slightly to the downside' and 'in its conduct of monetary policy at low interest rates, the Bank retains considerable flexibility, consistent with the framework outlined in the April 2009 MPR'. While the BOC retained the warning that persistent strength of the Canadian dollar would dampen growth, the market has turned more bullish in Canada's economy and pushed CAD higher.

Concerning economic outlook, leading indicators indicate strong GDP growth. 4Q09 GDP growth of +5% q/q (annualized) spurred speculations that growth in 1Q10 will probably exceed BOC's forecast of +3.5%. In fact, Canada's recovery has been broad-based and supported by robust domestic demand and US' growth outlook. Therefore, if the BOC begins the tightening cycle, the pace of rate hikes would be fast. There is also possibility that the central bank may increase the policy rate earlier than current estimated (end of 2Q10) should domestic data beat expectations.

Both Australia and Canada are commodity exporters with the former focusing on coal and iron ore exports to China which the latter a dominant energy exporter to the US. While the Chinese government maintains the pledge to achieve economic growth of 8% in 2010, the government has been speeding up tightening process to cool down lending. Similar to New Zealand, Canada will get hurt less severely if China speeds up the cooling process.

Persistent weakness in the euro and the pound amid sovereign crisis in peripheral European countries should benefit CAD the most among the 3 commodity currencies under observation, given Canada's bigger debt market. The chart below shows Canada's debt market is much bigger than that in Australia and New Zealand. Investors will be inclined to a more liquid Canadian debt market should they seek portfolio diversifications.

While we believe AUDNZD has overshot, our positive view on CAD hinges mainly on Canada's stronger growth outlook. Among the 3 commodity currencies in our universe, Australia's economy has turned out to be the most robust so far but Canada is quickly catching up. For New Zealand, recovery is in progress but disappointing employment report and housing sales prevent us and the market from being overly optimistic over its growth prospect. As Canadian dollar has not been running as fast as Australian dollar, we expect CAD to outperform both AUD and NZD in coming few months.