By Jason Pearce
Birds of a Feather
This blog post focuses on the Australian dollar/New Zealand dollar spread. However, there are points that will also benefit readers who are interested in the Australian dollar on its own merit and also readers who are interested the overall view of the commodity markets. Thanks for reading!
There is a very strong correlation between the Australian dollar (often referred to as the “Aussie”) and the New Zealand dollar (nicknamed the “kiwi” after the bird that is the nation’s icon). That’s to be expected. Most of New Zealand’s exports go directly to Australia, so the Kiwi economy basically acts like a mini version of the Australian economy.
The currencies of these two countries are joined at the hip. Look at the weekly price plot of the last two decades and you will see that they move together. However, one can sometimes move faster than the other. This can create spread trade opportunities.
Historic Spread Levels
The Australian dollar trades at a premium over the New Zealand dollar. Perhaps this is due to the fact that it’s the bigger of the two economies. Whatever the reason, the size of that premium fluctuates.
Over the last two decades, the Aussie/Kiwi spread has provided good buying opportunities whenever it has dropped below 4 cents (premium Aussie). It has only happened a handful of times, but each occurrence was followed by a rebound over the following months.
When the spread sank below 4 cents in 2003, it quickly recovered and rallied 729-basis points (about seven and one-quarter cents) into the spring of 2004.
In September 2004, the Aussie/Kiwi spread traded below 4 cents again. It then surged a little more than four cents over the next two months. However, the spread quickly backed off again and was confined to a trading range for the next year.
After a final low of 3.60 cents was established at the beginning of December 2005 the spread began an eleven and three-quarter cent rally over the next five months.
The Aussie/Kiwi spread breached the 4-cent level again in December 2014. It didn’t bottom until the second half of April 2015 when it hit a historic low of 0.61 cents. Despite the fact that new lows were made in the spread and it was argued that, because of changes in the fundamentals, “it’s different this time”, the spread reversed sharply and rallied nearly nine cents in just over two months.
2016: Third Time Is the Charm?
The spread fell back below the 4-cent mark last October. From there it rallied a little over three cents. It wasn’t the start of a new bull market, though.
The Aussie/Kiwi spread sank below 4 cents again at the start of this year and then rallied to 8.7 cents by the end of Q1. Still, it was not the sustained move we would hope for.
On Thursday, June 9th the nearest-futures Aussie/Kiwi spread traded to a thirteen-month low of less than 3 cents (premium Aussie) and cracked the similar October and January lows of 3.65 cents and 3.7 cents. This was attributed to the Kiwi surging as much as 2% after the Reserve Bank of New Zealand left interest rates unchanged and then said they expect inflation to accelerate. Now that the magical 4-cent level has been breached for the third time, perhaps the turnaround that eventually follows will be the real deal and not just another multi-week bounce? Perhaps. After all, this spread has been stuck in a wide trading range for months now. A sustained breakout is overdue.
Historic Ratio Levels
As always, we like to use the ratio as a confirmation tool for spreads that we discuss. The ratio helps normalize a spread relationship. This is especially valuable when analyzing markets that are trading near their historic highs/lows.
In terms of identifying the bargain levels for the ratio, you want to look for a level that the ratio hits infrequently. Moreover, you want it to be at a level where the ratio does not spend too much time there when it does get hit.
In this case, a ratio of 1.1:1 (this is where the Aussie is priced 10% over the kiwi) seems to be the point where traders should start looking for buying opportunities. Sometimes the ratio will tag 1.1:1 and immediately turn around and rocket higher for months/years afterwards. That is what happened in late 1997, mid-2007, and Q4 of 2008.
At other times, the ratio hits 1.1:1 and chops around for months or even years before the inevitable trend reversal happens. This occurred in late 2002 and again in the second half of 2004.
Our current situation falls into the second category. The Aussie/Kiwi ratio hit 1.1:1 in December 2013. For the last two and a half years, it has been tethered to this level as it has not yet made a sustained move away from it. Considering how long this has been going on, the consolidation period is getting long in the tooth. A trend should manifest sooner rather than later.
Sinking Even Further
Now here’s where the situation gets even more compelling…
The Aussie/Kiwi ratio bottomed out at 1.05:1 in late 2005. This proved to be a historic low as a multi-year bull market followed, even though there were some sharp corrections along the way.
The ratio broke the 1.05:1 mark last year and hit a multi-decade low of 1.01:1 last spring. So not only do we have a consolidation period that’s longer than normal, but we’ve also got a new historic low established during this period. When things get this extreme in terms of both price and time, the pendulum will inevitably swing the other way.
Currency Trend Change
Many times, the Aussie/Kiwi spread will follow the trend of the Australian dollar. Therefore, it can be beneficial to know what’s going on in the underlying currency.
There are currently a couple of things that lend itself to the argument that the Aussie dollar has finally bottomed. If so, this would be a supportive factor for the Aussie/Kiwi spread.
First of all, the Aussie dollar peaked out at a record high in July 2011. So if the current multi-year low that was established back in January marks the bottom, then this bear market will have lasted for four years and six months. The longest bear market that precedes this one occurred between December 1996 and April 2001. The duration of this bear market was four years and four months. This time symmetry argues that the bear market is over.
Second, the Australian dollar crashed 38% from the highs during the 2008 financial crisis. For a currency, that’s a pretty severe routing! Now get this: the Aussie has once again decline 38% from the July 2011 top into the current bear market low. This price symmetry also argues that the bear market may be over.
I will point out, however, that the Aussie dollar dropped nearly 42% during the 1996-2001 bear market. That’s obviously a bigger percentage decline than the current bear market. There’s no rule that says the current 38% decline can’t be exceeded or that the 42% decline won’t be bested.
We should also consider the size of the price decline. The 42 and a half-cent decline during this bear current market is larger than the 34-cent decline during the 1996-2001 bear market and the 37.7-cent decline during the 2008 bear market. From this perspective, the current Aussie dollar bear market is bigger than the last two.
Another Sign of the Times
One technical indicator that we can monitor for confirmation of a trend change is the monthly 20-bar Moving Average. The Aussie dollar has closed below the monthly 20-bar MA every single month for over three years now. The bounce into the 2014 high ended after the Aussie tagged the monthly 20-bar MA and backed off. The currency poked its head above the monthly 20-bar MA again just two months ago, but quickly reversed and shed almost seven cents from the top. Needless to say, the monthly 20-bar MA has proven to be stiff technical resistance.
If the Aussie dollar finishes the month above the monthly 20-bar MA for the first time since April 2013 it will signal a bullish trend change. That could happen as early as three weeks from now. The 20-bar MA is currently at .7518 and the nearest-futures Australian dollar is trading at .7475, so it’s less than half a penny away.
And if the trend change doesn’t happen this month, the 20-bar MA will be even lower when the month of July starts!
Keep in mind that a close above the monthly 20-bar MA is not a sure thing buy signal. Nothing works all the time. If some claims that they have a magical Holy Grail signal that works every time, they are either liars…or just plain stupid. However, when this same signal was triggered after the 1996-2001 bear market and again after the 2008 bear market, multi-year bull markets in the Aussie dollar followed. So it’s certainly worth paying attention to.
There’s one more reason that the Aussie may be on the cusp of a major trend change and, therefore, the Aussie/Kiwi spread may be ready to finally leave its nest and fly north. That reason is the turnaround in the commodities markets.
The Australian dollar and the New Zealand dollar are often referred to as commodity dollars. Although we’re not currently discussing it in this post, the Canadian dollar is also considered a commodity dollar. This is because their economies are major commodity producers. As a matter of fact, Australia is the world’s third-largest gold producer.
To get a macro view of commodity prices, simply look at a commodity index. Comparing the price action of the last couple of decades of the Goldman Sachs Commodity Index to the Aussie dollar confirms the accuracy of the commodity dollar title. It is immediately obvious that the overall price trends are the same and the major turning points are often synched up together. If one can identify where commodities are going, the Aussie dollar can often be traded as a proxy for commodities. This is good news because the currency is a lot more liquid than the commodity indices.
The Commodity Bull Returns
Many commodity indices –including the Goldman Sachs Commodity Index– bottomed at multi-year lows in January. As a matter of fact, the CRB index even hit a multi-decade low! As it turns out, the commodity bear market that started from the 2011 top was the longest commodities bear market that has occurred in the last 115 years.
Furthermore, the size of the decline made it the third or second-largest commodity bear market in history, depending on which commodity index you’re looking at. After the rubber band has been stretched this far for this long, the odds are that the inevitable trend reversal in commodities would immediately be followed by a sizable new bull market.
Back in April, the Goldman Sachs Commodity Index made a month-end close above the declining monthly 10-bar Moving Average for the first time in nearly two years. This was a bullish development, especially when you consider that the rally into the 2015 spring highs –which marked the top for the year- was established after the GSCI neared the monthly 10-bar MA and backed down.
This same bullish trend change signal also alerted traders to the beginning of multi-year bull commodity markets in 1999, 2002, and 2009.
In addition, the GSCI is on the cusp of closing above the monthly 20-bar Moving Average for the first time in two years. The 20-bar MA obviously moves at half the speed of the 10-bar MA, but the trade-off is that it provides a higher accuracy trend change signal. This is because it is not as sensitive to monthly price changes, which helps smooth out the price trend. At any rate, a month-end close above the monthly 20-bar MA will confirm the trend change in commodities.
As goes commodities, so goes the Aussie dollar. As goes the Aussie dollar, so goes the Australian dollar/New Zealand dollar spread. By all appearances, it’s about to go NORTH. Trade accordingly.
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