Asiamoney: where next for a falling Australian dollar?

Asiamoney, June 2013

“The Australian dollar – the best is behind it.” This research note, from AMP Capital on May 2, reflects a growing murmur in Australia: that after an extraordinary decade in which the Aussie dollar went from being worth 48 US cents in 2001 to US$1.10 in 2011, its period of greatest strength may be over. As it is, the currency had dropped 8% in five weeks at the time of writing – but is there much further to go?

To answer that question, one must first ask another question:  what made the Aussie go up so much in the first place? Partly, it was a function of huge increases in commodity prices, which in turn were driven by greater demand for them in the emerging world, most obviously with the growth and industrialisation of China. 70% of Australia’s exports are commodities, so movements in commodity prices drive export earnings, and with them the currency. On top of that, Australia fared well through the financial crisis and retained both a stable economy – it is one of only a handful of AAA-rated states left in the world – and a high yielding currency, making it a favoured destination of foreign capital seeking a combination of safety and yield.

Correspondingly, as several of those drivers have faltered, the outlook for the Aussie dollar has become less clear. Commodity prices mainly remain at high levels but have been slipping, and Chinese growth is declining, while China’s shift towards a more consumer-driven model rather than purely industrial growth and infrastructure is negative for Australia as a commodity exporter. And more recently, interest rates have started to come down, reducing the yield differential which attracted so much cash into the country.

“The broad impression is that the A$ is overvalued on a purchasing power parity basis,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital. “This suggests the A$ could face downward pressure if some of the factors that have been holding it up reverse.”

One reason for the recent decline in the A$ is domestic: rate cuts at the Reserve Bank of Australia. The May rate cut to 2.75% was the clearest domestic prompt for the fall in the Aussie dollar against the US dollar (internationally, the prospect of an end to quantitative easing was equally important from the US side). One natural consequence of this is that the yield between Aussie dollar assets and others in the developed world is narrowing, and is likely to narrow further if the RBA cuts again to help a struggling economy.

“It seems to have some support around US$0.95-96 and so could have a short term bounce,” says Oliver, “but there is a high risk now that it will go lower, particularly with the domestic economy looking pretty weak and the RBA seemingly more focused on wanting the A$ lower. In other words, if the A$ doesn’t fall more and the economy remains soft, then the RBA will likely keep cutting till it does fall further.” JP Morgan, for example, expects two more rate cuts, in November and in early 2014, or earlier if data continues to be weak, although the pronounced decline since the last cut in May has probably taken any immediate pressure away.

Analysts say the consensus view on the Aussie/US dollar cross-rate at the end of this year is 98 US cents per Australian dollar, but some are still more bearish than that. HSBC, for example, is expecting 90 cents. Daragh Maher, senior FX strategist at HSBC, speaks of the three Cs: China, the commodity backdrop, and the carry trade. “The reason the Aussie has been so resilient to questions over those three Cs was a very strong link to the risk-on mood in the market,” he says. “But that relationship has begun to break down.” Not that that’s bad for Australia. “We have had a substantial pullback in the Aussie dollar but the RBA is still happy to characterize it as highly valued. We clearly view it as a correcting currency and to my mind, there is further to go.”

That said, the yield differential with major currencies may be narrowing, but it is most certainly still there. And even if Australia’s economy is flagging, it still looks dramatically healthier than most western peers. Both of these things support the currency.

“Over the next six to 12 months, we think the Aussie still has a lot of friends,” says Stephen Walters, chief economist for Australia and New Zealand at JP Morgan, although he believes in the short term there may be further downward trading. “Our interest rates are still among the highest in the world. When you look at interest rates in Japan, the US and Europe close to zero, our cash rate at close to 3% and 10-year bonds yielding quite a bit higher look very attractive.”

“The pool of AAA government bond markets has been shrinking for quite some time,” he adds. “If you look at the candidates who are no longer on that list it’s the US, the UK and France; there are only nine or 10 left in the world that are still AAA-rated. And a lot of central banks and sovereign wealth funds looking for these characteristics: high yield, moderate risk, AAA-rated, decent budget and debt positions. It’s simple arithmetic.” Combined with a view that the US is not as close to tapering off quantitative easing as many think, Walters concludes that in the medium term the Australian dollar is heading back towards parity with the greenback, not the other way around.

It should be remembered that weak currency is what most Australians, and certainly the central bank, want to see. How low is enough? “Well, that depends who you ask,” says Walters. “The central bank won’t give a precise answer, but will say ‘lower’. This week [June 7] when they announced an unchanged cash rate they said the currency is high. That’s code for ‘we’d love it to be lower’.” And if that’s the RBA view, exporters see a sharper need. “As a manufacturing exporter and they’d like it to be in the 60s. A tourism operator, even lower. But they’re not going to see those wishes come true.” A more realistic level of equilibrium for the economy, he suggests, would be the mid-80s.

Is the commodity boom at an end? Opinion here is divided, but even for those who think it is not, it is hard to find anyone who thinks there is long to go.

Oliver says the pattern for raw materials over the past century has seen 10 year secular upswings followed by 10 to 20 year bear markets, which can sometimes be just sideways movements. Upswings follow periods of mining underinvestment and are driven by a surge in global demand for commodities; downswings come when the supply of commodities picks up following the earlier upswing, but the pace of demand slows. “After a 12 year bull run since 2000 this pattern would suggest that the commodity price boom may be at or near its end,” Oliver says. In particular, Chinese growth is slowing at exactly the time when the supply of commodities is about to surge after record levels of mining investment globally, he says.

Walters says the resource boom is made up of three phases: the price boom, which has clearly happened; the investment phase, with a huge ramping up of spending on capacity, particularly in Australia’s case on LNG, iron ore and coal; and then an evolution towards exports. He says the question is how far along the second part we are, and whether the amount of investment that has been made has become a drag. “We think it hasn’t,” he says. “There is still upside to spending. We can track what mining and energy companies are doing and they have a lot more to do. But the peak is getting closer.” And it is probably coming at the year end, he says.

And when it does? “It doesn’t mean investment stops rising and goes flat. It will fall and fall sharply. There is a capex cliff, and ours in Australia will subtract about 2% off GDP. What is going to take its place? That is where the debate is in earnest.” The hope is that exports take up the slack in the economy as the currency naturally declines.

The other big external question for the Australian dollar concerns the outlook for China, which takes 35% of Australian exports, compared to less than 10% as recently as 2008. As John Woods at Citi says: “I would say it’s the strength of  China rather than domestic policy in Australia which is dictating the value of the Australian dollar.”

“It is critically important what happens there,” says Walters. The constructive view is that a drop in Chinese growth to, say, 7.5% is still plenty sufficient to support Australian exports. But the subtext is that China’s intention to broaden its base of growth away from urbanisation and towards consumers is not great for Australia. As Walters puts it: “Most consumers I know don’t buy iron ore. They buy shoes and cars, and unfortunately we don’t export those products. Over time, that’s a big threat to us.” Still, he considers that a 10-year theme, and over the next year remains reasonably positive on China.

Woods at Citi says that a raft of policy information due shortly from the Chinese government around urbanisation could be highly significant for Australia. “This is essentially a program to house, feed, clothe, educate, hospitalise and transport some 400 million people,” he says. “That could have a very profound impact on growth domestically in China, and on commodities in Australia.”

Another theme relevant to the Aussie is quantitative easing in the world’s biggest economies. “Quantitative easing in the US, Japan and elsewhere should be positive for the A$ as it means an increase in the supply of US dollars and yen relative to the supply of Australian dollars,” says Oliver. “And indeed it has been [positive].” There is a clear correlation between rounds of easing in the US and strengthening in the Australian dollar. But, again, this may be a pattern about to reverse: the pace with which the US will taper off its quantitative easing is a global debate, but it appears it won’t be long until the process begins.

Supporting the A$, central banks appear to have continued to buy in to the currency through government debt – not that this shows particular prescience on their part. “Buying by central banks looking to diversify their foreign exchange reserves and by investors allocating to a diminishing pool of safe AAA rated countries has no doubt played a role in boosting the A$,” says Oliver. “However, one can’t help but think that after a decade long bull market in the A$ – or bear market in the US$ – central banks are late to the A$ party.” As the mining boom fades, he expects this source of support to fade.

Oddly, the round of easing in Japan has not yet resulted in the sort of flows one might have expected into Australian dollar assets. “If you asked me three months ago which way capital flows would go if the Bank of Japan pulls the trigger on QE, I would have argued there would have been a lot of flow into Australia,” says Walters at JP Morgan. “It hasn’t happened: if anything, there has been a repatriation of capital back to Japan.” Similarly Maher at HSBC notes that although Australia continues to be attractive in terms of yield and strength, “the problem is the dynamic: the motion of the carry is not operating in Australia’s favour. US yields are rising and Australian yields are potentially falling. What’s the more important driver to a currency? The absolute level or the change? At the moment, the change in interest rate expectations is the most pertinent driver.”

Nevertheless over time Walters does expect that money to arrive, which would both support the currency and increase the vulnerability to outflows of a country in which 75% of government bonds are already held overseas.

“The bottom line,” says Oliver, “is the best has likely been seen for the A$ and the risks are on the downside over the years ahead as the commodity price boom fades, allowing the A$ to correct some of its overvaluation on a purchasing power parity basis.”

“With fair value on the basis of relative price and cost comparisons being around US$0.75-80, it is likely headed down towards these levels.”