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Yield Inversion, Trade War & the Aussie

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Commodity currencies have been in for a bit of a roller coaster lately. And there are some signs in the economic data that show it’s likely to continue!

For the Aussie and it’s Kiwi counterpart, there are quite a few indicators pointing to further weakness in the coming months. The question is, though, whether their exchange counterparts will offset the trend.

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One of the more recent events that have put a damper on interest in commodity currencies was the official inversion of the bond yield curve on Wednesday.

We previously discussed what this means in terms of a recession, but how does that affect other currencies? For that, we have to analyze the influence of the trade war, and the recent dip in the Chinese currency.

The Trade War is Still On

A few days ago the Trump administration disclosed that planned tariffs on Chinese goods would be delayed, which the market interpreted as a cooling of the trade war. This came just a couple of days after the yuan fell below the psychologically important 7.00 level.

The White House interpreted this as a deliberate move by Chinese authorities to avoid the impact of the tariffs. China was put back on the currency manipulation list in response.

The thing is, the point of tariffs is to increase the cost of Chinese goods being sold in the US. This would put pressure on China to offer concessions to the US, primarily to change laws regarding intellectual property.

By weakening the currency, China could reduce some of the effects of the tariffs by making its exports cheaper. In the context of a threat of 25% tariffs, Deutsche Bank calculated that China could offset the price increase if the USDCNY dropped to 7.40.

Deliberate or Not?

China argues that the weakness in the yuan is not artificial, and is a natural consequence of the trade war. If the US buys less Chinese products, the logical consequence is that demand for yuan to pay for it will go down. In fact, as we pointed out a few months ago, the Chinese currency did fall with the imposition of tariffs and has been trending lower ever since.

While the US and China can argue over whether the weakness in the yuan is deliberate or not, from an analytical point of view, the effects on other currencies and markets are practically the same. This is what impacts the Australian dollar.

The Wider-Ranging Effects

A weaker yuan makes it more expensive for Chinese firms to buy raw materials to manufacture goods. One of the major imports is iron ore from Australia.

Iron ore has been climbing in price since the beginning of the year. This is due to supply issues after the collapse of the Vale Dam, one of the largest ore producers in Brazil. During that period, the price appreciated over 30%. On top of that, the yuan lost around 10% of value. That is a major increase in the cost of raw materials for Chinese firms, which were also struggling to sell their products in the context of the trade war.

At the end of July, Vale finally started to ramp up production of ore in Brazil (currently at 45% of capacity, planning to add an additional 20% by the end of the year). At the same time, Chinese officials took issue with the price of iron ore. There were concerns about other commodities, but they singled out iron ore as becoming too expensive. In the two weeks following, the price of ore has dropped a little over 15%.

Australia and the Yield Curve

Ore exports have been a key component of Australia’s recent record trade surpluses. These help support the strength of the Aussie dollar (and, by arbitrage, the Kiwi counterpart). However, with the price dropping, it’s likely to have an impact on the currency.

And with fears of a recession brewing due to the trajectory of the yield curve, the thought among a lot of investors would likely be to hold off on capital expenditure in case of a stronger economic downturn. That means buying less steel.

On the other hand, with the yield curve inversion, chances of further cuts by the Fed have increased quite a bit. The ECB also is likely to become more accommodative. But Australia has extra risk factors which just might put it ahead of the pack in the race to the bottom.

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