China, FX and Commodities: Unravelling the Complexities
Is the AUD the obvious buy because of the latest headlines from China?
Has Beijing finally delivered the policy boost needed to kick-start the Chinese economy? Economists will continue to debate whether these latest measures provide effective stimulus. In the meantime, traders are eyeing classic China trades for short-term opportunities. After all, with China-related trades being out of favor for so long, there is potential for a sharp positional squeeze even as the jury is still out on the long-term impact of the policy.
For FX investors, the Australian Dollar (AUD) is often seen as the go-to expression for China-related trades. Yesterday’s news pushed AUDUSD to its highest level since last summer, aligning with a 3% rise in copper prices and significant gains in mining stocks like Rio Tinto and BHP. Is the AUD a straightforward buy just because of the latest headlines?
China + Commodities ≠ Obvious FX Trades
"Obvious" trades don't always tell the full story. Relying on simple correlations between the AUD, copper, and China can be misleading. Macroeconomic relationships are much more intricate, involving multiple interconnected variables. Even when two factors appear to be correlated, this alone is insufficient for crafting reliable trading strategies.
AUDUSD & Copper: The Importance of a Holistic Picture
At Quant Insight (Qi), we employ a proprietary version of Principal Component Analysis (PCA) to model FX more comprehensively. This approach has two key advantages:
- Dimension Reduction: PCA helps identify the most critical factors driving asset prices from a wide array of potential influences.
- Orthogonality: It isolates independent patterns of association between asset prices and their drivers, enabling us to determine whether AUD is truly trading off copper prices, or if other factors—such as the Reserve Bank of Australia (RBA)—are playing a more significant role.
This method avoids simplistic conclusions like “AUD is overvalued given the copper sell-off” or “buy AUD on the back of the China news” by considering the broader macro environment.
The chart below shows a simple AUDUSD and copper price chart. In April, rallying copper prices failed to lift the currency. In August, the AUD rallied harder than copper “justified”. And now once again the FX move looks extended posing the question is the AUD overdone or copper lagging?
The Qi Approach to AUDUSD
Qi’s models go beyond just metal prices when assessing AUDUSD. We incorporate:
- Crude oil prices
- Interest rate differentials (both real and nominal)
- Growth differentials
- Credit spreads
- Proxies for sovereign stress in China and Europe
By accounting for these factors, we calculate where the cross "should" trade—this is our Qi model value, represented by the blue line in the charts. The spot market often gyrates around this value, overshooting in both directions. These deviations, or “Fair Value Gaps” offer potential trading opportunities.
For example, on August 1, AUDUSD was 2.1% undervalued compared to aggregate macro conditions. It caught back up to macro fair value over August but, by month-end, had overshot and sat 1.5% rich to model. Qi’s FVGs alerted FX players to these overshoots which are, in effect, trading opportunities.
Now, after the Chinese stimulus plan, AUDUSD once again appears to have rallied too-far-too-fast relative to prevailing macro conditions. Qi’s Fair Value Gap is over one standard deviation – AUD rich to macro.
Why? Decomposing Qi fair value into the various macro drivers we can see higher copper prices have lifted model value higher. But there’s been an offsetting drag from European spreads. Wider sovereign (BTP-Bunds) and credit spreads (iTraxx XOver) have been a headwind.
The net effect is close to flat, i.e. aggregate macro conditions are flat-lining. Put another way, the macro picture is more mixed than a simple China / copper snapshot would suggest.
How could we be wrong?
Qi Fair Value Gaps mean revert so we need evidence to suggest that reversion occurs via the market catching up or down to macro fundamentals. There are, of course, times when the market is the more efficient discounting mechanism and it moves quicker than macro factors which then re-price accordingly.
In this instance, if the China news is “genuine” and French politics calms down enabling European sovereign and credit spreads to re-compress, Qi model value would march higher. If that is your world view, you disregard the signal. But you have a warning that until that scenario pans out, a rich Qi FVG means a fair degree of good news is already in the price of AUDUSD - these aren’t great entry levels to chase the China trade.
Regime change? The bottom section of the chart above shows Qi’s model confidence: how effective are our macro factors at explaining the variance of AUDUSD. Model confidence has been high and stable for a prolonged period.
But it has just edged below our 65% threshold for a macro regime. That could signal a change in factor leadership and shift in regime. That offers a potential health warning.
But counter to that, Qi offers a host of ways to test the veracity of any signal. Back-test Fair Value Gaps to measure their historical efficacy. Measure the correlation between Qi’s FVG and the spot price. By definition, high correlation means the mean reversion happens by the spot price correcting back to macro fair value.
Either way, investors are alerted to dislocations between any currency pair and the macro environment. It’s not just simple trade idea generation, there’s transparency on what’s driven the breakdown and how the gap has closed in recent years.
The Power of Qi in Investment Decisions
At the end of the day, Qi’s machine-learning processes offer traders an objective way to identify patterns and dislocations across FX markets. By combining sensitivity analysis with valuation insights, investors can generate trade ideas backed by data, while still having the flexibility to overlay their own discretion.
Trading AUDUSD as a proxy for copper and/or China has a long and established track record. But these relationships are not fixed. Patterns evolve and shift over time. Qi can help you uncover deeper insights that go beyond surface-level correlations.
This is the value Qi brings to any investment process, offering a holistic and data-driven approach to complex markets.