9 January 2014 FX Blueprint Thin end of the wedge Theme #5: Dingo unchained ▪ 2013 saw the largest fall in AUD/NZD in over 28 years. Behind the fall in the cross was a significant move in interest rate differentials. • With the cross near record lows we think the risk / reward from here favors AUD/NZD upside. As a result we would be long AUD/NZD at current levels. As shown in Figure 1, 2013 marked the Worst' year for the AUD/NZD cross since at least 1986. Interestingly, in prior years when the cross has fallen over 10% the subsequent year sees a significant bounce back. The 13.5% fall in 1987 to 1.0959 was followed by a bounce of 23.5% in 1988; while the 12.7% fall in 2002 (to 1.0727) saw a 6.7% bounce in the following year. With the cross ending 2013 at 1.0850 after a 14.0% decline, history would suggest some likelihood of a significant move higher in AUD/NZD over 2014. Of course there is much more to FX than history. From a more fundamental perspective we see a number of reasons to expect a move higher in the AUD/NZD cross through the course of 2014. The first is valuation. As Figure 2 shows, the AUD/NZD cross has traditionally found a base around 1.05 (with just below here therefore likely to serve as a good level to set any stop). Our valuation metrics (as published in Exchange Rate Perspectives) also find NW the most over-valued of the G10 currencies on a PPP and BEER basis. The NZD is around 33% 'expensive' on a PPP basis, versus the AUD which is 26% 'expensive'. On a BEER basis the NZD is 22% 'expensive', versus the AUD which is only 5% above 'fair-value'. As far as 'big picture' drivers of the AUD/NZD cross are concerned, it is hard to go past interest rate differentials as shown in Figure 3. Looking a little more closely at the last few data points in that chart it also appears that AUD/NZD has 'overshot' interest rate differentials to the downside. Indeed, the current interest rate differential would appear to be m