Australian Dollar Update

Graeme Salt Uncategorized Leave a Comment

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The Australian dollar is experiencing significant seller pressure today in response to a soft reading on the closely watched ‘flash’ manufacturing output index out of China. A ‘warning’ from S&P that it may downgrade Australia’s credit rating if political deadlock precludes meaningful repair of Canberra’s budget is also cited as contributing to the selling pressure.

The local dollar dipped below 73 cents this morning for the first time since May 2009. As of 1.30 pm Perth time, its low for the day is 72.7 cents at around 11.00 am.

The cumulative depreciation of the Australian dollar since it started to retreat in April 2013 is now 31 per cent – still less than the 37 per cent precipitous peak to trough fall in late 2008, but significant nevertheless.

Exporters would no doubt salivate if the currency dipped as low as the 61 cents it hit in late October 2008 – the darkest days in the immediate aftermath of the collapse of Lehman Brothers 7 week earlier. But the local currency recovered quickly back then. By new year’s day of 2009 it was back at 70 cents; it hit 80 cents by the first day of winter of that year; 90 cents in early October; en-route to a monthly average peak of 108 cents in July 2011 – the same month the RBA’s multi-currency denominated index of commodity prices peaked.

Given the choice between a steep fall in the $A followed by a recovery almost as sharp compared to a more modest but sustained fall, exporters will chose the latter any day.

The Australian dollar isn’t the only ‘commodity currency’ to come under pressure in recent weeks – so too the Canadian and NZ dollars are falling. The Bank of Canada lowered its equivalent of the RBA’s cash rate target last week, while its kiwi counterpart did the same thing this week – both citing, amongst other things, falling commodity prices.

Actual and prospective commodity prices are by no means the only driver of exchange rates, although they are flavour of the month in FX markets just now. As of June, on a monthly average basis, the RBA’s commodity price index had fallen by 47 per cent since its July 2011 historical high. But the Australian dollar had only dropped by 28 per cent over the same period against the US dollar, and an ever gentler 18 per cent on the currency’s trade-weighted index.

Conversely, commodity prices rose by more 300 per cent during their multi-generational bull run, but the Australian dollar rose by just a touch over 100 per cent – from its April 2001 low of just 50 cents, to its July 2011 high of 108 cents.

One of the key reasons the $A stayed ‘stronger for longer’ in 2012 even as commodity prices were falling centred around foreign central bank appetite for Australia’s AAA rated sovereign debt. So while the ‘warning’ from S&P was a long way short of strident, the FX market has latched onto it nevertheless as posing a risk that what came in 3 years ago could just as easily go back out if Australia’s debt rating were to be cut.

More generally, the Australian dollar has ‘benefitted’ from high interest rates down under compared to most other advanced economies, especially those whose central banks had to resort to unconventional monetary stimulus – the US, UK, the euro area and Japan.

Unconventional monetary policy is still in play in all four, but the Fed is carefully laying the groundwork to tighten both conventional and unconventional monetary policy, most likely before the end of this year by giving the all clear to the first increase in the federal funds rate since June 2006.

So prospective, and to some extent actual interest rate differentials that have favoured the Australian dollar for so long are already narrowing. The current pull-back in the currency can be directly traced to when the Fed fist flagged its intention to ‘taper’ the asset purchases by which it was conducting unconventional monetary policy in April 2013. The first couple of moves by the Fed are probably already priced in to the Australian dollar at around 73 cents. But as and when the reality that global interest rates will not stay near zero for much longer, downside risk to the Australian dollar is significant, particularly if the US dollar’s ascent does not stall again.

Since the Asian currency crisis of 1997, the Australian and US dollars have moved inversely to each other – in contrast to the first 14 years of the floating of the local currency in December 1983, when the two dollars moved in tandem.

And unless the post 1997 relationship breaks down, the waxing and waning of the Australian dollar will be dominated by the trajectory of the US dollar. If the Fed does not raise the funds rate this year, the big dollar will retreat, or at least go sideways for a time. But if the world’s only reserve currency continues to march higher, local exporters could yet get their wish for a 60 cent Australian dollar. That is not our base case expectation by any means, but the local unit is more likely to fall through 70 cents in coming weeks than once again threaten to rise back through 80 cents.

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