-Fund manager hedging drives Australian Dollar rout into month-end.

-But Aussie unit to recover in April as effect of hedging flows fades away.

-Large national savings pot is lifting the Aussie's fundamental value.

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The Australian Dollar could be owed a rebound in the forthcoming week, according to strategists at Commonwealth Bank of Australia, as month and quarter-end hedging activity among institutional money managers dies away.

Australia’s unit has come under renewed pressure in recent days, which has forced it to a new 2018 low against the US Dollar, making for 0.31% loss since Monday and a -1.76% loss for the year to date. This contrasts against a 0.41% gain for the US Dollar index this week.

Commonwealth Bank attribute this move to Australian money managers, who hold some A$ 400 billion of offshore stocks and A$120 billion of offshore bonds, making adjustments to hedges that are designed to protect them against movements in foreign exchange rates.

“AUD will come under some selling pressure (and USD under some upward pressure) as month-end and quarter-end hedging flows transact through the market. At the time of writing, the world MSCI index is down 3.3% for the month of March. This implies that Australian-based offshore equity managers may be over-hedged on their offshore equity assets,” says Richard Grace, chief currency strategist at Commonwealth Bank.

Above: AUD/USD rate (thick red) plotted against the US Dow Jones Index. Source: Netdania Markets.

Typically, an Australian investor would bet on a rise in the AUD/USD rate (buy the Australian Dollar) in order to hedge the foreign currency risk of holding US Dollar assets. The investor would gain on the hedge trade if the Australian Dollar rises over the period but would see a decline in the Aussie Dollar value of its foreign investment portfolio at the same time. The net effect on returns would be neutral.

However, a 3% fall seen by the MSCI World Index in March, as well as steeper falls earlier in the first quarter, may have left some managers of Australia’s offshore assets “over-hedged” if they are attempting to maintain a hedge ratio that is a constant portion of their overall portfolios.

To maintain a constant hedge ratio investors would need to reverse some of their earlier hedges to take account of fall in value of the MSCI index, which would involve selling some of the Australian Dollars acquired as hedges over the month and first quarter as a whole.

“Exactly how much AUD the funds have to sell is difficult to ascertain,” says Grace. “We will stick to the more volatile equity hedge adjustments, where the approximate average hedge ratio is 30%. Hence, the stock of equity hedging is some $120 billion. Hence, a 3.3% variation in the world MSCI index equates to some A$3.9 billion of required AUD selling at this month’s March month-end.”

Grace and the Commonwealth Bank of Australia team acknowledge there are many unpredictable variables that could influence the overall scale of the tweaks that fund managers make to their hedges but say at least half of the changes will be concentrated in the AUD/USD exchange rate, with just 10% for the Pound-to-Ausse. Researchers at the Reserve Bank of Australia estimate the true amount of AUD/USD hedging activity could be a much larger share of the total given that 85% of Australian Dollar turnover in derivatives markets is concentrated on this one exhange rate.

"Attempting to make square these complications, we believe net intra-day hedge-related selling of AUD of a few billion will occur as we approach the end of the March quarter. But AUD should recover soon afterwards," says Grace.

The AUD/USD rate was quoted 0.08% higher at 0.7665 during morning trading in London Thursday, the final session of the month and quarter, while the Pound-to-Aussie rate was down 0.23% at 1.8338.

Above: Pound-to-Australian-Dollar rate in March.

"Australian assets under management continue to expand and have become an important part of global capital flows. The size of Australia’s retirement superannuation assets at the end of 2017 was A$2.6 trillion, and there is significant additional funds under management outside of the Australian superannuation system," Grace adds. "An increasing proportion of these savings funds are being invested overseas."

The implications of Australia's growing pile of national savings could be significant for the Aussie Dollar over the medium and longer term, according to Grace, as the country's increasing tendency to invest this money in offshore markets means the world now has a net liability to Australia that is growing by the day. This has a positive effect on the so called fundamental value of the Australian Dollar.

"Australia now receives more foreign dividends than it pays out in dividends to non-residents. This development has, along with relatively low interest rates on Australia’s foreign debt servicing requirements, has led to a long-run structural improvement in Australia’s net income deficit. In turn, this has generated a structural improvement in Australia’s current account deficit. This in turn feeds into a higher valuation of the AUD," Grace writes, in a note Thursday.

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